Strong Stimulus from the European Central Bank
You don’t often see the words "Central Bank" and "bazooka" in the same sentence, but last week gave us a stunning exception to that rule. Multiple economists and journalists referred to last week's stimulus program from the European Central Bank (ECB) as a "bazooka." Neil Irwin of the New York Times chose a different metaphor, referring to ECB President Mario Draghi's actions as "...throwing the kitchen sink at Europe's economic distress. Again."
Kitchen and military metaphors aside, the ECB has dramatically increased its economic stimulus package with a multi-pronged approach designed to spur Eurozone economic growth and stave off potential deflation. Anemic quarterly GDP growth in the Euro area has ranged from 0.4% growth to 0.4% contraction since 2011 with only one exception (0.6% growth in Q1 2015). EU inflation was 0.3% in January but fell to -0.2% in February. Core inflation, the rate that excludes energy and other volatile components, dropped from 1.0% to 0.7%. ECB staff economists cut their 2016 inflation predictions from 1.0% to 0.1%, and expect inflation to stay well below 2% through 2018.
Clearly, the ECB had to act, and Draghi has obliged. What are the details of the ECB stimulus package, and do the reactions of the market so far suggest that it will be successful?
An Attack on All Fronts
Two of the four elements were welcome, but unsurprising: The ECB lowered its benchmark lending rate of 0.05% to zero, and the overnight deposit rate for banks even further into negative territory from -0.3% to -0.4%. The global experiment with negative interest rates continues, as central banks try to find a true lower boundary now that the threshold of zero has been broken.
The asset purchase program, however, was a surprise to many. Monthly asset purchases were raised from 60 billion euros to 80 billion ($67 billion and $89 billion respectively at Friday's closing exchange rate). To keep the supply of eligible bonds from running out, non-bank corporate bonds will be included in future purchases. It could be a potentially tricky proposition to spread corporate stimulus in equitable and useful ways across the EU. Stimulus of this nature may benefit countries unequally, depending on the quality of each country's available corporate bonds.
The fourth element is a funding-for-lending operation known by the awkward acronym of TLTRO (targeted longer-term refinancing operation). Four such efforts will be launched between June 2016 and March 2017, providing loans to banks of four years with interest as low as their current deposit rate — which is presently negative. The more any bank issues in loans they keep on their books, the more they will be allowed to borrow — and the closer the interest rate will get to their lowest rate.
In other words, the ECB is easing the pain of charging banks to hold their money by essentially paying them to borrow money back and make loans. It's a clever way of using the bizarre world of negative interest rates to maximize stimulus.
Always Give Them Hope
The markets seemed to react positively to the initial news. The Euro fell from $1.097 to $1.084, while European equity markets rose, and bond yields fell — all desirable results from the Eurozone perspective. Unfortunately, in remarks following the action, Draghi put a wet blanket on the market by suggesting that the ECB does not intend to cut rates any further.
This is probably a wise strategy, as the long-term effects of negative interest rates remain uncharted. However, it may have been unwise to say so publicly immediately after enacting a rate cut. Thinking Draghi was signaling that the ECB had reached the lower boundary of interest rate cuts, investors rapidly reversed course. Stock markets in Germany, France, and Great Britain fell anywhere from 1.8% to 2.3% and the Euro shot back up to $1.1218 for one of the biggest single-day swings in the history of the currency. It's not easy to produce a large economic stimulus package and depress markets, but the ECB managed to do so by failing to address the psychology of the situation.
It's fair to wonder why markets reacted this way. After all, Draghi made a similar proclamation when interest rates were cut to -0.2% in September 2014. At the time used the phrase "now we are at the lower bound." Why would things be any different now? Perhaps the markets realize, as does Draghi, that continually dropping interest rates further into negative territory runs the risk of doing serious harm to a banking system that is built on the assumption of positive interest.
ECB stimulus is likely to continue, but central banks can only do so much by themselves. Pumping money into the system only works if it is used wisely on the other end of the system. The plan seems to lend itself to a plumbing analogy: the ECB is putting pressure on banks in order to dislodge a "money clog" in the pipeline. The addition of corporate bonds helps pump money into the downstream portion of the pipeline and should relieve some pressure by encouraging businesses to borrow and expand.
Unfortunately, a driving force for the money clog is lack of demand. Businesses simply are not going to expand without a reason to expect their products will sell. That demand has to come from consumers with increased confidence in the economy (and sufficient money to spend) or direct government spending. So far, governments have not been willing to carry their load — and debt levels in many countries make that a difficult proposition.
Europe is experiencing an even slower recovery than the US, and in the Eurozone, this could produce a deflationary spiral. As an investor, you should be concerned about that prospect beyond its potential to roil European equity markets. Why? Because an ECB failure to prevent deflation will affect worldwide demand and exchange rates, and can have a profoundly negative impact on the broader US economy
Watch the market over the next few weeks and review your portfolio accordingly for any of your holdings that gather large profits from European operations, that sell primarily to Europe, or that are very sensitive to currency exchange rates. Also, keep an eye on any business-related governmental actions from EU member nations that either complement or contradict the EU action, and observe how the corporate bond purchases are allocated among countries and companies. The next several quarters represent an important test for the EU, as there are a limited number of bazookas left to fire, or kitchen sinks left to throw.