Macro: The Bottom Line (6/9/2014)

The ECB (finally) acts

 

After 2 years of mostly verbal interventions, the ECB finally decided last Thursday that it was time to get its hands dirty again. Faced with the same issues that we've been discussing for weeks - stubbornly low inflation and a strong euro that risked jeopardizing the fragile recovery - Draghi and company announced a slew of measures.

1. Interest rate cuts. The most headline-grabbing of these was the decision to cut the deposit rate from 0.0 percent to -0.1 percent. In other words, European banks must now pay 0.1 percent to park their excess liquidity at the central bank. By thus "punishing" banks for sitting on idle reserves, the ECB hopes to nudge banks toward more lending to the real economy.

Will it work? As novel as this idea sounds, negative interest rates are not without precedent. As recently as summer 2012, Denmark's central bank imposed a similar negative deposit rate (and the rate remained negative until April of this year). In the Danish case, the primary goal was to stave off strength in the Danish krone. On this count, the measure worked, with the krone weakening to more acceptable levels. But what about easing credit conditions? One of the interesting side effects of deposit rates was that banks found a convenient excuse to increase loan rates, precisely the opposite of what Eurozone policymakers would want to see. Add to the mix the possibility that liquidity will dry up for money-market funds, and you've got a very blurry picture. 

2. Expanding direct lending from the ECB to European banks. The ECB extended a provision (known as "fixed rate full allotment") that allowed commercial banks to borrow however much they wanted at a fixed rate for one week. In addition, they introduced a separate program whereby the ECB would lend banks funds for up to 4 years at uber-low rates, up to 7 percent of their total loan books. Given the current aggregate size of Eurozone banks' loan portfolios, the latter program could add about 400 billion euros of liquidity.

Will it work? Again, massive lending programs are not unheard of. The ECB itself unleashed its bazooka (over 1 trillion euros of 3-year, low interest loans) in late 2011/early 2012. The problem back then was that this cheap cash came with few strings attached, and a non-trivial portion of the funds got redeployed into sovereign-bond investments rather than towards lending to the real economy This time, the conditions are much stricter - the volume of new cash is directly tied to the aggregate amount banks lend to businesses and households. In theory, this makes logical sense, especially considering that the primary means of corporate finance in Europe remains bank lending. But let's not forget the root cause of the tight liquidity conditions in Spain, Italy, Portugal, and other peripheral countries. The recessions in these countries were so harsh, and the loan losses local banks suffered so severe, that the key element underlying any functional banking system - trust between creditor and borrower - disappeared. Even today, despite more stable macro conditions, this lack of trust (or "information asymmetry," in economist parlance) continues to handicap access to credit in several Eurozone countries. Until these root issues are properly addressed, throwing more funds at the problem is unlikely to do much.

3. Vague hints of QE. Aside from announcing these measures, Draghi noted that the bank was not necessarily "finished," and would initiate "preparatory work" towards stimulus measures for the ABS market. In other words, the ECB is keeping the door toward outright asset purchases open, especially in the market for repackaged loans. Again, a well-intentioned step that will run into a slew of practical complexities. How does the ECB avoid provoking potentially destabilizing fluctuations in a market that's not all that liquid? How do Draghi and his colleagues decide on the fair allocation of purchases between countries? How will they avoid creating undesired arbitrage opportunities between countries and sub-sectors of the ABS market? There are no simple answers to any of these questions. 

 

How did the markets react?

As we discussed above, the jury is still out on whether the measures will have their desired effects. But the markets certainly took it in stride. Equity markets on both sides of the Atlantic reacted favorably, with the S&P 500 edging ever closer to the 2,000 level. Even more impressive was the rally in peripheral European bonds, with Spain's 10 year yield falling to within 10 basis points of the 10-year U.S. Treasury yield. Outside the developed world, emerging market currencies from Brazil's real to South Africa's rand also had their moments in the sun. Just as we noted in our post from two weeks ago, the 2013 "consensus" is being unwound, and the era of easy money is making itself felt again.

What about the euro? Many would be surprised to learn that the currency not only didn't collapse after the ECB's announcements, but actually rose slightly. Does this contradict everything that we've been writing about for months? We believe not. You see, the markets had been pricing in ECB action for quite some time, and many institutional investors had been building up sizeable short positions in the currency. True to the maxim of "enter on the rumor, exit on the news," many of these investors took advantage of Thursday's news to unwind their shorts. But once the reality settles in - that inflation won't be anywhere near normal levels anytime soon, and the ECB will very likely need to keep its foot on the stimulus accelerator - the euro will likely once again find itself in the crosshairs of the markets.