The end of the road...

Financial Mirror (Cyprus) - - FRONT PAGE -

The new ECB poli­cies were cer­tainly bold. Monthly as­set pur­chases were upped to EUR 80bn from EUR 60bn, with their scope ex­panded to cover in­vest­ment grade non-bank cor­po­rate bonds. The de­posit and main re­fi­nanc­ing rates were both cut to -0.40% and 0%, from -0.30% and 0.05%, re­spec­tively; most im­por­tantly, a new Tar­geted Long Term Re­pur­chas­ing Op­er­a­tion was in­tro­duced. The TLTRO is the ECB’s at­tempt to off­set the squeeze on banks’ net in­ter­est mar­gins due to its im­po­si­tion of a neg­a­tive de­posit rate on ex­cess re­serves. The hope is to boost pri­vate sec­tor lend­ing with the sweet­ener that if the rise is big enough, the in­ter­est charged on this fund­ing will fall below zero, po­ten­tially as far as the de­posit rate.

So what went wrong? If the pol­icy works, banks will get paid to lend to pri­vate en­ti­ties which amounts to a sub­sidy to off­set the costs of poli­cies such as neg­a­tive rates with its flat­ten­ing (and profit damp­en­ing) im­pact on the yield curve. Mario Draghi showed that the ECB shares mar­ket con­cerns that neg­a­tive rates could hit bank prof­its. He also im­plied that the de­posit rate was now at its lower limit. The corol­lary is that the ECB has been forced to shift tack from tar­get­ing a weaker euro (through a lower de­posit rate) to ac­cept­ing that in­ter­est rate pol­icy has reached its lim­its.

Hence, the new pol­icy set­tings, with their i mplicit re­jec­tion of fur­ther de­pre­ci­a­tion of the euro, will have im­pli­ca­tions for the sin­gle cur­rency. While fur­ther rate cuts seem to have been ruled out, in­ter­est rates will be kept at their cur­rent low level for a long time as the last TLTRO will ma­ture in 2021. Hence, in the ab­sence of the eu­ro­zone fall­ing back into cri­sis con­di­tions, the euro will largely be driven by US mon­e­tary pol­icy.

Thurs­day’s ECB move also re­in­forces the gath­er­ing mar­ket meme that mon­e­tary pol­icy has run out of road. The sug­ges­tion from Draghi was that Europe’s politi­cians have been granted a breath­ing space and must step up with more struc­tural re­form poli­cies. He char­ac­ter­ized such growth­boost­ing mea­sures as hav­ing been “fairly lim­ited”, adding that they “need to be stepped up in the ma­jor­ity of eu­ro­zone coun­tries.”

It is also im­por­tant to put TLTRO neg­a­tive rates in some kind of his­tor­i­cal con­text. For decades cen­tral banks propped up their com­mer­cial brethren in times of low growth and ris­ing bad debt by cut­ting short term in­ter­est rates and steep­en­ing the yield curve. The prob­lem to­day is that with long rates hav­ing fallen far faster than short rates, and in many economies be­ing neg­a­tive out to eight year ma­tu­ri­ties, that game no longer works. By pay­ing banks to lend, the ECB is at­tempt­ing to recre­ate this dy­namic, but the ef­fect will likely re­sem­ble a group of teenage friends meet­ing in late middle age and try­ing to re­pro­duce the wild times of their youth.

Hence, bank stocks are prob­a­bly still not worth buy­ing and there re­mains the non-ma­te­rial risk that the next sub­sidy for banks could ac­tu­ally be an out­right na­tion­al­iza­tion. Even more of a worry is a po­ten­tial re­sump­tion of the cen­trifu­gal forces that a few years ago were pulling the eu­ro­zone apart. In the ab­sence of a fis­cal union and with ris­ing political stress in light of the mi­gra­tion cri­sis, the main uni­fy­ing dy­namic in the sin­gle cur­rency area has been mon­e­tary pol­icy and cross­bor­der fi­nan­cial flows. One wor­ry­ing tail risk would be the re­al­iza­tion that this pol­icy has run out of road, re­sult­ing in the eu­ro­zone again fac­ing an ex­is­ten­tial threat—a Brexit vote in June could be one such trig­ger.

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