Erik Jones / Nov 2016
Photo: Wikimedia Commons
The surprise victory of Donald J. Trump in the United States (US) presidential elections briefly pushed the euro, the Swiss franc, and the Danish kroner up against the dollar. It also pushed down the yields on high quality sovereign debt and it temporarily sent equity markets into the red. This is all to be expected. Like almost everyone, market participants thought Hilary Clinton would gain the White House alongside a predominantly Republican Congress. They placed their bets to take advantage of another four years of competent administration and legislative logjam. A Trump victory upset that calculation. Now those market participants are trying to safeguard their capital until they can get a better sense of what is happening. The assumption is that Europe can act as a safe-haven. Unfortunately, that assumption is mistaken.
Europe's economy is not a good place for investors to hide their assets and the tendency to use Europe as a safe-haven is making matters worse. The reason is different for different parts of the continent. The story for the small countries like Switzerland is straightforward. Whenever international investors use the Swiss currency as a safe-haven, the Swiss franc tends to appreciate in the markets. The only way for the Swiss central bank to fend off that pressure is to push its policy rates ever deeper into negative territory. In turn, those negative interest rates create problems for the Swiss banks. This is a dynamic that the Swiss central bank has experienced for a long time now. So far the effects have been manageable, but any flow of flight capital from the United States to Switzerland will only make matters worse. The same is true for other small north European countries, like Denmark and Sweden.
Within the euro area, the problem has to do with the European Central Bank's (ECB) large scale asset purchasing programme. That program hinges on the ECB's ability to buy high-quality assets in relatively strict proportions according to their country of origin and at prices low enough to ensure that the ECB will not take a loss on its purchases. The implication is that the ECB needs to buy approximately EUR 1.4 in assets from Germany for every EUR 1.0 worth of assets from Italy. Given the high price of safe German assets in the market, finding enough for the ECB to purchase has become an increasing problem. Once again, any purchases made by US investors will only make that problem worse.
Additional demand for euro-denominated assets will also put upward pressure on the euro-dollar exchange rate. This constitutes a source of monetary tightening for the euro area. Yet the whole reason the ECB is purchasing assets is to make monetary policy looser. This means that the ECB will have to find some way to add more stimulus. This is going to be challenging given the constraints on the large-scale asset purchasing programme. There are few other instruments left in the mix. The ECB already charges banks for holding their deposits and it has offered banks targeted long-term refinancing opportunities at negative rates of interest if they use the money they borrow to lend to the non-financial sector. So far this policy mix has had only a limited (if still positive) effect.
This is where politics becomes important. Germany faces national elections in the early autumn of 2017. Therefore, German politicians are reluctant to see the ECB loosen monetary policy further. The ECB could purchase more assets, lend more money, or even lower interest rates further, but that will be hard for German politicians to accept. German politicians would be particularly reluctant to see the ECB purchase assets in a disproportionate matter. They do not want to give the impression that the ECB is rewarding countries that have too much debt. Hence, the more international investors try to shelter their assets in Germany-originated instruments, the more tension they create between the ECB and the German political class. The ECB could quickly run out of maneuver as a consequence. This would not only make it hard for monetary policy makers in the euro area to extend their loose monetary policy far into 2017 but it would also leave them ill-prepared should the euro area experience some other shock.
That shock could be right around the corner. The Italian people have a national referendum scheduled for 4 December of this year. That vote is to approve a raft of constitutional reforms and so will determine whether the government of Italy has the decisiveness to reform the country's economy or whether Italian politicians will spend the next few months redesigning their electoral system and preparing for early elections. This is not a life-or-death choice for Italy, but investors are concerned that the Italians will deliver a 'no' vote and that this will slow down economic performance both now and in the future. If that happens, many investors will move out of Italian sovereign debt and into other relatively risk-free assets including those in Germany. This flight to quality will add additional pressure onto the price of German-originated bonds and so make the ECB's job all the more complicated.
It would be bad enough if Donald Trump's election set off a chain reaction in the bond markets that brought the ECB's large-scale asset purchasing programme to a premature conclusion. It would be worse if this complication emerged alongside a controversial Italian referendum outcome. If the ECB could not purchase Italian-originated assets at a time when investors were looking to sell out of their positions, the spread between the yields on Italian and German government bonds could move quickly upward. This would raise fears that the euro area may be headed back into a sovereign debt crisis and such fear would only exacerbate the situation further. The ECB was the only actor powerful enough to stop that kind of market spiral in 2012; this time it would be more constrained in trying to do so.
No rational investor would want to see this doomsday scenario unfold in Europe. Investors would be particularly disillusioned if they started out this whole process by relying on Europe as a safe-haven. Hence it would be better if investors started with the assumption that the euro area is not a good place to keep their capital from risk now that Trump has been elected President. Neither are the smaller European countries like Denmark, Sweden, and Switzerland. If anything, Europe is an unsafe haven for investors looking to safeguard their assets. That was true before the US elections; it is even more true now that Donald Trump has been elected president.