Growth is still low … Yet to recover from the 2008-crisis, the global economy faces below-potential growth prospects. Until the developed world pays down sovereign and corporate debt, deleveraging and unemployment will constrain the recovery. Frail consumer confidence, sluggish demand and the ensuing drop in consumption in advanced economies will not be offset by final demand in emerging markets, where most countries still rely on export-led growth. While global output remains subdued, Europe real GDP growth stagnates. In Q1-2014, the economy of the Euro Zone (EZ) was more than 2 percent smaller than in 2008. In the same period, GDP rose by 0.3 percent in the 28 European Union (EU) countries and by 0.2 percent in the 18 EZ countries. Until the EZ periphery undergoes needed structural transformations, growth will be too fragile to counter a low, declining inflation.
… EZ inflation keeps declining … A key indicator of a fragile recovery is an inflation-rate below 1 percent. In May, EZ annual consumer inflation weakened to 0.5 from 0.7 percent in April, increasing deflation risks. Promptly, the European Central Bank (ECB) revised its forecasts down, and it is now expecting inflation to rise at 0.7 in 2014, 1.1 in 2015 and 1.4 percent in 2016. While such forecasts still look optimistic, they are below ECB’s “2-percent target”.
… and the ECB came to the rescue. On May 5, 2014, the ECB announced a “package of measures” to push inflation towards its target. All 24 members of the ECB Governing Council unanimously supported the package, including the conservative Bundesbank President Weidmann. Key measures include:
1. Interest rates cut. All 3 main ECB interest rates were reduced:
a) Policy rate – ECB’s short-term lending rate, called the “refinancing rate”, was cut by -10 basis points (bps), down to 15bps (0.15 percent); this is a 7-day liquidity window to banks, held weekly (on Wednesdays), and used in Main Refinancing Operations (MRO).
b) 1-day borrowing rate – the rate the ECB pays on banks’ overnight deposits, called the “deposit facility rate”, was cut by -10bps, down to -10bps (a negative nominal rate of -0.1 percent); such decision:
i. is unprecedented: the ECB becomes the first major central bank to bring one of its main rates below zero;
ii. entails that the ECB will charge banks on their ‘excess reserves’ – currently €120bn – held at the central bank; in other words, banks will pay a penalty for not lending their deposits onto the economy.
iii. is likely to impact both money and repo markets; and
c) 1-day lending rate – the rate the ECB charges on banks’ overnight borrowing, called the “marginal lending facility rate”, was cut by -35bps to keep the symmetry of the rate corridor – down to 40bps (from 0.75 to 0.4 percent)
2. Introduction of Targeted Longer-Term Refinancing Operations (TLTROs), worth up to €400bn. As of September 2014, the ECB will offer refinancing to banks via new TLTROs, with a four-year maturity (up to September 2018) and a rate fixed at the time of take up – based on the ECB’s main refinancing rate, plus a fixed spread of 10 bps (i.e.:, 0.25 percent). The first 2 operations will be held in September and December 2014. The intent of the measure is to spur lending to non-financial private sector, along the lines of the Bank of England (BoE)’s Funding for Lending Scheme; however, the ECB focus is on lending to businesses, rather than to households for home purchases via mortgage-lending (as in the BoE’s case). Banks can borrow from the ECB an amount equal to 7 percent of their “current loan book to households and businesses, excluding mortgages”, for a total of €400bn. If banks were to take advantage of the full allotment, the TLTROs could expand the ECB balance sheet by 20 percent.
3. End of the sterilization of Securities Market Program (SMP), worth up to €119bn. The ECB will no longer “sterilize” – by withdrawing each week an equivalent amount of liquidity – the inflationary effects of its 2010-2011 government bond purchases. This measure will increase excess liquidity in the EZ financial system and make more effective the negative deposit facility rate. Also, it de facto constitutes a ‘mini quantitative easing (QE)’ program, as it allows for an immediate injection of the amount sterilized with the last operation, i.e. €119bn.
4. Preparatory work on Asset Backed Securities (ABS) purchases. By launching this initiative, the ECB is preparing the grounds for buying, along the lines of the US Federal Reserve’s QE program, privately-created asset-backed securities. The ECB could purchase ABS with underlying assets consisting of loans to the non-financial sector. Draghi said such securities would need to be “simple, transparent, and real.” Mortgage Backed Securities were not excluded as an option.
5. Full allotment for ECB operations extended from mid-2015 to end-2016. By extending fixed rate tenders procedures – i.e.: MROs, Medium Term Reps, etc. – to end-2016, the ECB committed to meet in full – rather than by auction – banks’ general liquidity requirements.
More easing to come. In the press conference, Draghi acknowledged that almost all of policy makers’ conventional tools were exhausted and left the door open to more action, by saying “Are we finished? The answer is no”. Should inflation remain low – and it will – the ECB will expand its balance sheet, by scaling up TLTROs and, if needed, launching a QE-like large-scale program of asset purchases.
Good intentions, but plenty of unintended consequences. The above described set of instruments is expected to: a) spur lending in the EU periphery; and b) weaken the Euro. Yet, both expectations will prove difficult. In theory, more bank lending is to be expected. In practice, the purchases of government bonds will increase, sustaining the Euro and hampering long-term growth.
A. Banks will prefer to buy bonds, rather than lend to businesses. The TLTRO conditions are designed for commercial banks to take up cheap ECB funding and lend it into the real economy, rather than spend it into government debt. By April 2016, banks must show their “net lending to the non-financial private sector” to be greater than in the previous 12 months. Otherwise, they must start repaying the capital they borrowed. However, the region’s banks – still in the process of rebuilding their balance sheets – are hampered by the ECB’s Asset Quality Review, expected to finish in H2-2014. Also, banks have to repay the ECB €450bn by February 2015, as 2 previous LTROs expire. The TLTRO documentation – approved by the Bundesbank – does not prevent banks from: a) taking up ECB funding during the first 2 years; b) buy government bonds or use the TLTRO funds to repay existing LTRO loans, de facto extending them at a cheaper rate (25bps vs 65bps); and c) pay a penalty in 2016 and start repaying the TLTROs, 2 years in advance.
- The “Draghi bond-put” is on: expect sustained bond purchases by banks … Most EZ banks will increase their demand for domestic government bonds, as cheap finance allows them to rebuild capital via an attractive long-term spread, at almost no risk. ECB loans cost 0.25 percent, and Italian or Spanish 10-y bonds yield about 2.7 percent. Lending to small and medium enterprises (SMEs) would be far riskier. In the press conference, Draghi specified that the LTROs “are not there to incentivize carry trade”, but reality is likely to prove him wrong. The ECB package is a de facto “bond-put”, particularly for the EZ periphery, where monetary expansion will lead to bonds yields compression.
- … and foreign investors. In a global context where there is: 1) below-potential growth and subdued inflation; and 2) abundant policy-induced liquidity, investors flock into bonds. Past experiences show that in such context the appetite for bond purchases is independent from the level of debt and the presence of growth-impairing structural issues. In Japan’s well-known case, government bonds yields declined over 15 years, despite debt-to-GDP ratios at more-than-twice the size of the economy and a rapidly ageing population. In the EZ, the same trend unfolded over the past 2 years, and it is likely to continue. Across the globe, fixed-income investors – looking for protection from US monetary policy normalization and comforted by exceptionally loose, longer-than-expected EZ monetary conditions – will buy EZ government bonds, because of their attractive yields in inflation-adjusted terms.
B. The Euro will not weaken that easily. Domestic and foreign flows will put downward pressure on sovereign spreads, bring about yield compression, and counter currency depreciation. In other words, investors chasing bonds will bring about Euro strength. Since the crisis, the Euro as proven to be highly correlated with asset markets of the EZ periphery.
- Short term: Euro strength. According to the ECB, both a) market expectations about additional measures; and b) the deposit rate cut should put downward pressure on the currency. Yet, without a large-scale asset purchase program (QE), they are unlikely to be sufficient. A “liquidity differential” still plays in favor of Euro strength. The ECB package – about €520 billion (around $700 billion) is – so far – announced, potential liquidity: it is bound to start in September 2014. Meanwhile, the Fed is pumping real liquidity into the markets, every month. Under its QE program, the Fed initially purchased long-term treasuries and mortgage-backed securities for $85 billion per month ($1,020 billion per annum). Recently, QE was tapered to $55 billion per month in March 2014, and to $45 billion in May (equivalent to $540 billion per annum). To devalue the Euro in the short term, the ECB needs print more. Otherwise, a strong Euro will erode the EZ competitive position (what is good for EZ fixed income markets is not necessarily good for exporters) and will keep pulling inflation below ECB’s “2-percent target”, creating the conditions for further easing.
- Long term: Euro to weaken. Eventually, sustained ECB monetary policy easing – while other major central banks tighten up and seriously contemplate raising interest rates – will weaken the Euro. A depreciating currency might help export-oriented EZ economies, push up import prices and trigger an increase in headline inflation, but not necessarily lead to a growth pick up. In the UK (2008) and Japan (2012 and 2013), the combination of: a) rising inflation; and b) lack of growth resulted in real-household-income erosion.
C. Without reforms, growth will stagnate. The world economy is in the middle of a lost decade, and global growth is likely to languish below potential for a few more years. Following the Japanese pattern, in most countries liquidity injections brought about increased bond purchases and falling yields – even as debt levels rose. True, in the US, EU and Japan, bond-buying is keeping long-term interest rate down, helping the process of household and company re-leveraging. Yet, lower sovereign debt yields do not always feed through into easier credit conditions. In turn, anemic credit growth keeps growth below-potential and fragile, calling for central banks’ to support the recovery with sustained easing. This process is likely to keep going until most banks are re-leveraged.
- Central banks cannot create growth; they can at best prevent it from dropping. Globally, most monetary authorities now bear most of the policy-making, but are in experimental territory. The ECB is committing itself to four years of ultra-cheap funding. The extension of ‘fixed rate tenders procedures’ until end-2016 and a fixed interest rate on four-year TLTROs until September 2018 represent an extension of the ECB’s “forward guidance” with respect to interest rates. Yet, debt is likely to crowd out credit: to repair their balance sheets banks will prefer not to lend to risky borrowers, and focus on their own re-leveraging – by borrowing from the central bank and buying government bonds – eventually hampering growth. Going forward, monetary expansion will inevitably be less effective in stimulating aggregate demand, hence unlikely to achieve job-creation.
- Bailing out politicians in the EZ periphery prevents needed reforms. The ECB may eventually stimulate more bank lending, but Europe does not really need cheap money; it rather requires broad economic reforms. In Japan, while the Bank of Japan’s liquidity injections helped exporters by wakening the Yen, Prime Minister Shinzo Abe failed to implement his ‘third arrow’ – i.e.,: domestic economic reforms. Like Japan and unlike the US, the EZ runs the risks of stagnating growth and deflation, as it is burdened by an aging population, high taxes, inflexible labor markets, overregulation and limited business competition and – as a result – minimal innovation. Hoping to facilitate the implementation of structural economic reforms, the ECB keeps providing Europe’s politicians with easy money. Yet, falling bond spreads reduce the incentive for elected officials to carry out politically-unpalatable reforms. Inevitably, German savers will feel penalized by less fiscally prudent countries.
- Despite high liquidity, disinflation to persist; inflation unlikely any time soon. Inflation is low across the globe. Going forward, EZ disinflationary pressures are likely to outweigh inflationary ones. Because of a combination of below-trend GDP growth and high unemployment, unused capacity in good and labor markets are likely to override upward pressure on prices, mostly driven by food and oil costs. Additionally, several factors will reinforce downward pressures, such as private sector deleveraging, reduced bank lending, cost-containment, productivity increases, and demographics – as older people have lower spending propensity. In such conditions, further falls in inflation are likely and Japanese-style deflation quite conceivable. The latter would weaken spending, raise the real burden of debt and make adjustments in competitiveness more difficult.
- In this environment, corporations remain on hold. As sales, profit margins and corporate earnings might suffer, the corporate world lacks the confidence needed to make significant business and investment decisions. Unable to properly assess the economic outlook, businesses are reluctant to make longer-term choices about adding workers and capital spending. As business confidence suffers, firms remain unwilling to invest and tend to choose leaders oriented to cost-cutting rather than expansion. Large companies, even when cash-rich, contain capital expenditures and cut corporate research and development. Small and medium-sized firms, a major source of job creation, lost access to capital.
Investment implications: expect bonds outperformance in the EZ periphery. With respect to the past decades, investors face a very different, and more difficult, investment environment. The probability of future financial shocks, and black swans, is still high. Capital preservation via a defensive asset allocation is priority. ECB’s additional round of central bank liquidity is likely to support global markets and emerging markets’ currencies, but – going forward – bonds are still likely to outperform stocks. No doubt, the bond market has grown increasingly complacent, and most analysts are concerned about its over-valuation. But the factors that push demand for public debt are still there: stagnating growth, disinflation, private sector deleveraging, liquidity, skepticism about risk-assets, and banks in need of balance sheet repair. Also, most central banks want commercial banks to re-leverage, support bond markets and keep long-term interest rates at low levels. As long as this powerful combination is there, the bubble-in-the-making is unlikely to burst. Banks and investors are likely to keep parking central-bank-liquidity in bonds, as it happened in Japan.
 Against recent readings of 2 percent in the US, 1.6 percent in the UK, and 1.5 percent in Japan (after adjusting for the recent increases in sales taxes).
 Since 2008, core inflation – the price-level long-term trend, excluding transitory price changes and volatile items like energy, food, alcohol and tobacco – averaged 1.3 percent. In May it was down to 0.7 percent.
 Simply put, Japan government bonds (JGBs) had more buyers than sellers. While 95 percent of JGBs are held by Japanese, and local pension funds accumulate long-term JGBs to match their liabilities, banks were the largest buyers. Facing anemic growth and deflation, companies refrained from investing, paid off loans and kept cash into their bank accounts. Banks, facing a scarcity of worthy borrowers, parked their deposits into JGBs. Shorting JGBs, nicknamed the “the widow-maker”, proved financially fatal, at whatever yield the trade was made: 3 per cent in 1996, 2 per cent in 2002, 1 per cent in 2011. Investors kept flocking to the bonds, pushing yields down and prices up. Every year, Japan was able borrow more cheaply. Bond traders betting against JGBs lost, spectacularly.
 In the US, inflationary expectations are on the rise, and some government-bonds investors are facing negative real yields.