The end of the road...
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.