Did The European Central Bank Just Give Us All a Get Out of Jail Free Card?
What happened: The European Central Bank (ECB) cut all policy rates, increased Quantitative Easing (QE) to include corporate bonds and expanded a facility (TLTROs) to prevent banks from being adversely impacted by negative interest rates[1].
Why did they do it: They had to! The Eurozone is experiencing low inflation, weak growth and has limited appetite for fiscal stimulus. This led the ECB to enact broad measures to stimulate growth and encourage bank lending while giving a boost to Net Interest Margins. The measure moves further into so-called “unconventional monetary policy” and the economic community is divided on its interpretation of the likely efficacy and possible unintended consequences of such moves. ECB president, Mario Draghi, said the outlook for the global economy and volatility in financial markets since the start of the year heightened the risk that a recent fall in consumer prices would become “entrenched.” Deflation that is caused by demand destruction or overcapacity is antithetical to growth and a scourge for debt issuers as it makes repayment more expensive in real terms.
What sector is most impacted: Banking. Normally negative rates are quite difficult operating environments for banks. Papers from Investor’s Business Daily to the Financial Times were filled with articles the day before the ECB meeting warning of the risks of negative rates to banks. When central banks charge banks to keep excess deposits at the central bank rather than lend out those deposits there is an implicit assumption that the banks can do something prudent and profitable with the excess deposits, they simply choose not to. To the extent that there is unmet demand for bank loans, this measure will assist banks that lend because the TLTRO facility effectively pays European Banks to borrow money from the ECB (for a four year period).
In short TLTRO facility should help shore up bank balance sheets. Much of the equity and European corporate debt market volatility year to date can be linked to problems in the European banking sector[2]. This is, therefore, a significant move and one that should calm markets on both sides of the Atlantic.
What are some possible unintended consequences: Negative interest rates are not a panacea. Switzerland was the first to enact negative rates in December 2014 in an effort to prevent its currency from appreciating. It did not work. Switzerland gave up trying market intervention and took rates to -1.25% to no avail. Japan also took its rates negative on January 29th of this year and since then the Japanese Yen has appreciated just over 5%. Not a resounding success as a currency weakening tool. The initial reaction of the currency markets to the ECB action was for the EUR to weaken by 2%, however by the end of the day it had appreciated by 2.0%. This came after comments from Mr. Draghi that perhaps there would be no further rate cuts. The problem with this statement and the ensuing market reaction is that a weaker currency (and stronger exports) is one of the key ways the Eurozone sees economic benefits from negative interest rates. We believe it is very likely the ECB will choose to expand QE if more stimulus is required.
A more problematic unintended consequence could stem from market signals and the impact on wealth as these two reinforce each other in a most unfortunate way. The market signal the ECB wants to convey is that it is committed to encouraging economic activity and investment spurred by bank lending. However, investment since the Great Recession has been lower than the past four post-recession recoveries. This is despite record low, sometimes even negative, interest rates. One possible reason is a signalling error. Such extreme central bank action may unintentionally signal that it believes low growth prospects are entrenched and investment is not a prudent activity. This could be why we see so many share buy backs and dividend payments. Corporations see value in paying dividends and buying shares over investing cheap money in future growth.
Linked to this is a concept that negative interest rates are a way to “tax” wealth that does not invest in riskier assets such as high yield bonds and equities. When government bond rates are negative, the investor pays the government to lend it money. This is a tax! In Japan where savers prefer bonds and there is a very low inheritance tax combined with a weak government, this is one way to extract a tax and reduce government debt. Especially so since raising inflation in the hopes of inflating away the debt did not work. Europe looks to be trying a similar strategy and on Friday March 11th the Italian government borrowed at negative rates for the first time. (By the way, Italy is a country with high savings, high government debt ownership, very low inheritance taxes and a growing government debt to GDP burden due to deflation.)
What does this mean? European banks may very well be saved thereby reducing a major risk to not only European growth but to the U.S. as well. Equity markets are likely to go up as the near term incentive to choose equities over bonds has been increased. Governments that issue bonds at negative rates, currently over 25% of the global bond index is negative, are receiving a tax payment that helps them reduce debt and improve fiscal balances.
What is less certain is if negative rates will cause investment to increase. Greater investment is required to shore up long term growth prospects, increase productivity and improve living standards. In this regard we are in the midst of a great economic gamble that theory says will work out okay. In the short term, Draghi just gave us a Get Out of Jail Free card[3].
[1] The details of the six part ECB decision announced on March 10, 2016 impact a variety of rates. The Governing Council of the ECB took the following monetary policy decisions:
(1) The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.
(2) The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.
(3) The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.
(4) The monthly purchases under the asset purchase program will be expanded to €80 billion starting in April.
(5) Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.
(6) A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.
[2] Asset managers were hedging their exposure to COCO bonds, convertible bank bonds designed to pass a portion of any losses to investors rather than to the public sector. As COCO bonds fell in value market participants hedged by shorting bank stocks, thereby reducing bank equity and risking further problems in the banking sector.
[3] With thanks to a brilliant friend who is a leader in the economics and asset management community.