Why the ECB will not turn Japanese
European bank stocks have enjoyed a near 5% bounce in the last two trading sessions of last week on hopes that the European Central Bank will follow its Japanese counterpart by explicitly adopting policies that help steepen the yield curve and so lessen the squeeze on bank lending margins. There are reasons to be more cheery about the outlook for European financials, but a Japanese-style rescue mission may not be one of them.
Last Wednesday, the Bank of Japan re-committed itself to maintaining monetary stimulus until CPI exceeds its 2% target, while also anchoring 10-year government bond yields near zero, thereby facilitating a curve steeping. Given that Japan has been a laboratory for “creative” monetary policies and the eurozone faces Japanese-style deflationary headwinds, a plausible argument can be made for the ECB to follow suit.
After all, the problems that the BoJ’s new policy framework seeks to address also exist in the eurozone, namely, (i) a “dis-anchoring” of inflation expectations, (ii) a scarcity of assets for the central bank to buy, and (iii) bank profits taking a hit from negative interest rates. Moreover, the ECB last month tasked a committee to assess the case for new asset purchase options.
The reason to think the ECB will not follow suit is that while the eurozone faces similar broad challenges to Japan, the specifics of its situation are significantly different. Consider the following:
- While eurozone inflationary pressure subdued there are signs of it bottoming out.
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The ECB’s forecasts for HICP inflation—which have been steadily revised lower since quantitative easing was adopted early in 2015—have been stable since March, and forecasts point to the measure gradually rising toward the ECB’s target by late 2018. Also 5-year/5-year inflation swaps—which measure expectations for inflation over a five year period starting in five years time—are trading at a two month high.
- The ECB’s asset scarcity problem is not as acute as the BoJ’s.
Such a constraint will only materialise should the QE program, as we expect, be extended beyond its scheduled expiry next March. As such, the ECB has time to play with. Also, any further upward rises in global bond yields will extend the moment when scarcity seriously kicks in, as bonds now yielding below -0.4% rise back above the threshold that make them eligible for ECB purchase.
- Profits at eurozone banks have been hit by negative deposit rates, but an offset has come from a pick-up in lending.
In addition the ECB has been supporting banks through long term funding based on negative rates (TLTRO2). Banks can borrow from the ECB at no cost and get paid if they increase lending to the real economy by specified amounts. On Thursday, the results of the second allotment from the TLTRO2 programme were announced, showing EUR 36 bln being taken up, compared to an expected 22.8 bln. The implication is that eurozone banks want to capitalize on negative rates and expect to boost lending.
Another reason to think that the ECB will not follow the BoJ’s lead in directly targeting the yield curve lies with concerns of “unreformed” members of the eurozone receiving direct “monetary financing”. As the eurozone is made up of 19 different sovereign yield curves, such an approach would require sovereign spreads to be eliminated, which would necessarily involve the “capital key” being jettisoned as the basis for deciding how much of each country’s bonds the ECB buys. This mechanism was adopted in response to German concerns that a non-mechanistic asset buying program would facilitate soft monetary financing, largely flowing from north to south.
While Germany’s constitutional court softened its stance on this issue earlier in the year, at the point that the supply of bunds available for the ECB to buy starts to dry up, it is unlikely that anything other than targeted and temporary bond-buying deviations from levels dictated by the capital key will be accepted.
For this reason the recent euphoria among investors in eurozone bank stocks looks a little overdone. There are reasons to believe that a cyclical eurozone recovery and a lessening of deflationary pressure will resuscitate bank profits, but it will be a slow business and a Japanese-style quick fix is probably not in the cards.