Today’s main story is the ECB’s decision to lower the overnight lending rate to 0.15% from 0.25% and to take the ECB deposit rate to -0.10%. The idea behind the negative deposit rate is: If banks have to pay the ECB to store money, maybe they will lend it out instead. Of course, banks could just buy 10-year sovereign debt, earn higher risk-free returns and have the ability to use sovereign debt as collateral in repo transactions should they need liquidity (potentially increasing the demand for European sovereign debt). This leaves QE as (more or less) the only tool left in the ECB’s box. However, the ECB is not independent and cannot unilaterally launch QE asset purchases.
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Fire All of Your Guns at Once
ECB President Mario Draghi did allude to QE when he announced that the ECB wishes to encourage mortgage securitization so the ECB would have securities which it could purchase as part of an asset purchase mechanism. The European MBS market is but a small fraction of the U.S. market. Instead, European banks tend to issue covered bonds or pfandbriefs. Covered bonds are corporate bonds issued by banks which are backed by a pool of mortgages or other loans. The bond indenture lays out the amount, type and quality of the mortgages or loans securing the bonds. Following the U.S. financial crisis, covered bonds were suggested as a possible replacement for MBS in the U.S. as, unlike with private-label MBS, a covered bond is an obligation of the issuing bank, An MBS issued by a bank is usually not, in any way, an obligation of the issuing bank.
It was thought that, if banks had skin in the game, they would be less likely to issue riskier mortgages, thereby preventing asset bubbles and reducing risks to the financial system. What has happened in Europe is that banks (many with toxic assets littering their balance sheets and having not raised much capital), simply stopped lending to all but the highest-quality borrowers. This has helped restrain economic growth. It is hoped that the ECB’s lower benchmark rate (0.15%) and a negative ECB deposit (-0.10%) would encourage (pressure) banks into lending. This will probably provide some benefit, but (as with many developed economies today) the Eurozone is face with structural issues. Homeownership is looked upon differently in Europe versus the U.S.
Entrepreneurism is not as prevalent and business regulations and protections often prevent new startups from entering the market. Mr. Draghi might have arrested disinflation and he might only generate a modest increase in inflation. This is not a fix for the Eurozone’s problems. As Mohamed El-Erian stated as we were wrapping up this segment, the ECB is “buying time” for fiscal and structural change in Europe. We are hopeful that European leaders will see the light, but with their constituents resistant to change, we would not hold our breath.
I can’t get your love, I can’t get satisfaction Uh-oh, bond market, psychotic reaction
It appears that the bond market is of a similar mind. Following Mr. Draghi’s press conference, the yield of the 10-year German bund spiked to 1.487% before falling to 1.415% at the time of this writing. The bond market reacted to what was considered to be more aggressive action and language than expected. However, the reality that the ECB’s policies and plans, although helpful, were unlikely to cure what ails the Eurozon set in . The euro reacted in a similar, albeit opposite, fashion. The euro was trading at just over 1.36 versus the U.S. dollar. Following Mr. Draghi’s announcement, the euro fell to 1.35. The euro is trading at about 1.362 versus the USD at the time of this writing.
We would like to remind readers that, unlike the Fed, the ECB is not an independent entity. Before engaging in quantitative easing, Mr. Draghi needs the unanimous approval of sovereign member central banks. It appears as though the bond market viewed today’s announcement largely as jawboning which might not ever come to fruition.
It is our view that the global economy is settling into a scenario of modest to moderate growth and modest to moderate inflation. Because of a global competition for labor and business, monetary policies might have to be more accommodative than in the past to generate trend (give or take) economic growth. This could especially be true if fiscal policies maintain the status quo.
This leaves Bond Squad in the rather dull position of forecasting neither especially-low nor alarmingly-high interest rates. Our base case is for long-term rates to rise modestly during the next year or two, but to not rise to very high levels. We believe that the Fed will raise the Fed Funds Rate gradually and moderately. It is our view that interest rates will have to be lower than their historical norms to generate trend economic growth for the foreseeable future. The push/pull from foreign monetary policies designed to manage economic growth and inflation should greatly influence both Fed policies and long-term U.S. interest rates.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
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