Why New ECB Stimulus is Unlikely to Revive European Economy

Why New ECB Stimulus is Unlikely to Revive European Economy

by Kathy Jones, Schwab Center for Financial Research

Key Points

• The market reaction to the European Central Bank's (ECB) latest plan to revive the European economy was less than enthusiastic, as investors sent the euro higher and bond yields lower.
• Although the ECB's four-part plan sounds bold, its financial reach is likely to be small, so the moves aren’t likely to have a huge impact, in our view.
• The rally in European bonds has contributed to foreign purchases of U.S. Treasuries, underlining the global nature of bond markets.
• We’ve lowered our expectations for rising long-term Treasury rates this year to a potential peak of around 3%.

Over the past few years the European Central Bank (ECB) has developed a reputation for having a "big hat, but no cattle." ECB officials have talked a lot about stimulating the European economy, but haven't done too much. Two years ago, the ECB President, Mario Draghi, famously promised to do "whatever it takes" to save the euro. He succeeded in stabilizing the currency enough to bring down interest rates in the highly indebted European countries without actually doing very much.

But saving the euro is one thing and reviving economic growth is another. The European economy has barely recovered from recession, deflation is a reality in southern Europe and is at risk of spreading to the north, and credit is contracting. Now the central bank is going where few central banks have ventured—into the world of negative interest rates. But the market reaction to the ECB's latest plan was less than enthusiastic. Investors continued sending the euro higher and bond yields lower.

10-year bond yields converging globally at lower levels

Source: Bloomberg. 10-Year Treasury Constant Maturity Rate and Long-Term Government Bond Yields: 10-year. Monthly data as of May 30, 2014.

In Europe, bond yields are at new all-time lows for many countries, and the spread between high and low is narrowing. The last time yields converged in Europe was prior to the financial crisis in 2008, but the average yield at that time was over 4%. Yields are once again converging, but now the average yield is 2.5%.

If the markets actually believed the ECB's actions would be effective in expanding money supply, preventing deflation and boosting Europe's sputtering economy, it's more likely that long-term bond yields would rise and the currency decline. That's what happened in U.S. markets during each round of quantitative easing by the Fed. Easier monetary policy typically means a weaker currency and a steeper yield curve.

The ECB's four-part plan sounds bold, but isn't bold enough. Here's why:

1. Negative short-term interest rates will affect a small amount of money. The rate on deposits held at the central bank will be moved to negative 10 basis points, or -0.10%, meaning banks with excess reserves will be charged for keeping the money with the ECB. A basis point is one-hundredth of a percentage point, yet the deposit facility held less than 30 billion euros as of the end of May. Relative to Europe's 9.5 trillion euro economy, it's not likely to be enough to make a difference. The euro could fall further against other major currencies in the long run because it will cost more to hold the currency due to the interest rate penalty. But the initial market reaction suggests that deflation concerns may offset the negative deposit rate. Deflationary pressures can boost a currency because when prices are falling, the currency buys more in the future than it did in the past and the supply of money contracts.
2. The ECB is proposing to provide more liquidity to the banks, but not more capital. The ECB introduced a "funding-for-lending" program called Targeted Long Term Repo Operation (TLTRO). Under this program, the central bank will extend four-year loans to banks at a fixed rate of 25 basis points in exchange for lending. Banks will be able to borrow up to 400 billion euros, but if they don't lend, they will have to give the money back.
   The problem is that the banks have ample amounts of liquidity, so access to more liquidity may not produce more lending. It's capital they need. Lending is weak because of soft demand by creditworthy borrowers and because banks need to shore up their capital to meet regulatory requirements. The more banks lend, the more capital they need to hold. European banks are currently undergoing stress tests to assess if they have enough capital. The results won't be out until October, so in the near term, it seems unlikely that they will be willing to aggressively increase lending
3. The impact on money supply growth is likely to be small. The ECB will stop "sterilizing" its purchases of sovereign bonds, allowing money supply to grow. Sterilization is when money pumped into the financial system is taken back out through the issuance of short-term debt. There are questions as to whether the move to halt sterilization is legal, since it has been contested by the German courts in the past. Moreover, the central bank only holds about 165 billion euros in the Securities Market Programme (SMP), so there isn't that much to sterilize.
4. Expansion of the ECB's balance sheet is likely to be slow. The ECB will look into buying asset-backed securities (ABS) to hold on its balance sheet. This proposal is similar to quantitative easing and probably has the potential to have the most impact on Europe's economy, but there were scant details provided as to when or how this plan will be implemented. What assets will be purchased and at what price? And, the size of the ABS market in Europe is small relative to the size of the European economy, so it could take some time before there are enough securities purchased to have much impact on the ECB’s balance sheet.

Implications: It's a global bond market

Central bank policies are diverging but bond yields are converging. The ECB is trying to provide more monetary stimulus to the European economy and the People's Bank of China is easing policy and weakening the yuan, but the U.S. is moving in the opposite direction: pulling back on its easy policy. The contrast is likely to be highlighted at the next Federal Open Market Committee meeting June 17-18.

Recent U.S. economic data, including the employment figures and credit growth, have been upbeat and deflation worries are abating. But it's a global bond market and much of the buying in U.S. bonds recently has been from foreign investors. Foreign buying has outpaced everyone else since late last year—even the Fed.

On a cumulative basis, foreign buying has been higher over the past three years than the Fed's buying. So the rally in bonds is not just about the Fed. It's also about the attractiveness of the U.S. Treasury market relative to other markets. As of March 31, foreign investors hold 47.3% of all outstanding U.S. Treasuries, compared to the Fed at 18.4%, households at 6.7% and pension funds at 5.4%. The rest is distributed between commercial banks, money market and mutual funds, and broker/dealers.¹

Foreign investors have been the largest cumulative buyers of Treasuries over the last three years

Source: Federal Reserve Board of Governors. Federal Reserve Statistical Release Z.1 Financial Accounts of the United States, First Quarter 2014.

For U.S. bond investors, the ECB's plan underscores the global component of the Treasury bond market rally this year. As low as they are, U.S. 10-year bond yields are among the highest in the developed world.

After the huge rally in European bonds over the past year, U.S. 10-year Treasury yields are 135 basis points above 10-year German bond yields and only slightly below yields in some of the southern European countries like Italy and Spain. In fact, five-year Treasury yields in the U.S. are above those in Italy and Spain, countries struggling with heavier fiscal burdens and greater structural problems. By comparison, U.S. yields look attractive. As long as ECB policies continue to underwhelm, interest rates are likely to remain on the low side. One caveat: Draghi said that the ECB is "not done yet." Looks like Mario may be heading to the back 40 to round up more cattle.

Strategy and outlook: Reduce risk

We have lowered our expectations for rising long-term rates this year, looking for a potential peak closer to 3% than the 3.5% we expected earlier in the year. Higher risk sectors of the fixed income markets have benefited from the rally in the overall market, but with spreads narrowing and yields declining, there isn’t much room for error. We suggest being very cautious about high yield and other sectors with credit risk and/or lack of liquidity.

We still believe investors should start adding high quality, intermediate-term Treasuries and investment-grade corporate or municipal bonds as yields move higher, but current yields aren’t that attractive for adding duration. We’d suggest starting to dollar cost average as 10-year Treasuries move above the 3.0% level and not hold out for 3.5% or higher this year.

I hope this enhanced your understanding of global fixed income markets. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.

1. Federal Reserve Board of Governors. Federal Reserve Statistical Release Z.1 Financial Accounts of the United States, First Quarter 2014.