“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” – Mario Draghi
These were the famous words spoken by the president of the European central bank in 2012 during a period where uncertainty and high volatility were pushing sovereigns, financial institutions and non-financial corporations on the verge of bankruptcy. Fast forward 7 years and the impact that those exact words had on markets and investors’ confidence are clear and visible.
As we speak, the Italian 10 year treasury is trading at a lower yield than the US 10 year treasury. The US might currently be facing structural debt problems, however they are nowhere near Italian or Portuguese levels of debt. The US also has the ability to print currency, which debases its value, but eliminates the chance of actually becoming insolvent through a declaration of bankruptcy. Therefore the market’s pricing doesn’t rationally reflect the fundamentals. With a debt/gdp of respectively 132% and 130% for Italy and Portugal the only thing preventing these sovereigns from going bust are the artificially low interest rates resulting from the ECB’s monetary policy.
When exactly can investors expect quantitative tapering and what will be the effects of the ECB structurally lowering the volume of their asset purchase program? Should investors be fearful?
What it all comes down to is the inflation rate. There lies the key difference between the ECB and other central banks, namely the ECB is only concerned about inflation in the medium and long term. Other central banks, such as the Federal Reserve, have multiple mandates, and despite continually moving the goal posts are focused on other areas of the economy such as employment. This explains why the ECB decided to raise its key interest rates in 2008 in the midst of a financial meltdown while other central banks were reducing short-term interest rates.
To have a grasp of what impact quantitative tightening (QT) might have on markets, it’s important to understand why quantitative easing was conducted in the first place. The first instinctive reaction from every central bank to a financial/economic crisis is to lower short term rates and provide liquidity to markets in an effort to artificially induce capital flows. However, when the key interest rate hits the so called ‘zero lower bound’, a level at which central banks can no longer influence economic activity via a reduction in the interest rate, they are required to seek other tools and methods to artificially boost the economy and influence market decision making. As such, securities with a longer maturity also become a policy target.
One of the policies the ECB enacted in the aftermath of the financial crisis was extending the duration on the loans it provided to banks (LTRO). Additionally, the ECB started the asset purchase program (APP) by purchasing long-term securities from the public sector (government bonds) and later on expanded to the corporate sector (corporate bonds). The intent was to lower long term borrowing costs for sovereigns who were effectively insolvent and unable to issue their own currency, since they were using the Euro. Additionally, this provided liquidity for companies, particularly those whose bonds had a non-investment grade rating. These actions resulted in the ECB pushing investors up the risk curve in a search for yield, into riskier assets.
- March 2008 – The ECB offers its first supplementary LTRO with a six-month maturity is more than four times oversubscribed with bids from 177 banks.
- June 2009 – The ECB announces its first 12-month LTRO that closes with over 1,000 bidders in sharply higher demand than previous LTROs.
- December 2011 – The ECB announces its first LTRO with a three year term with a 1% interest rate and usage of the banks’ portfolios as collateral.
- February 2012 – The ECB holds a second 36-month auction, known as LTRO2, that provides 800 euro zone banks with 529.5 billion euros in low interest loans.
The same way quantitative easing pushed investors into riskier assets, quantitative tightening will push investors into safer assets, since it removes the moral hazard and the induced benefit of a central bank pushing asset prices higher. As such, junk bonds (non-investment grade) in Europe, are akin to subprime mortgages in the US in 2007 – a ticking time-bomb. Investors justify the holding such toxic assets because they are overestimating the ability of the ECB to alleviate financial conditions and create sustainable economic growth in the long term. Recency bias is a dangerous price to pay. The future, is not the same as the past.
You don’t create a sound sustainable economy by printing currency, that’s what is the root of problems, not a solution. It would be unfortunate to repeat the same mistakes of the past, except this time on a much larger scale. The misallocation of capital caused by interest rates manipulation has contributed to the structural problems the European Union faces, resulting in a significant financial disparity between countries in the union, as well as low productivity growth and relative high unemployment.
There is an increased risk for the Euro economy to decline as soon as the ECB begins to taper its monetary policy, which is likely to force long term rates higher, increasing funding costs for companies and governments. Investors will realize their mistakes and come to their senses. Governments will find it more difficult to finance their activities, which means they will inevitably have to drastically cut spending or go bust again. Short term rates will depend on the evolution of the inflation rate which continues to show an upward trend, suggesting we might have higher short term rates in the near future. Negative Interest Rate Policy (NIRP) didn’t incentive governments to reduce expenditures and put forward structural reforms, as such, when interest rates rise it will create a negative catalyst even though some countries have taken advantage of the low rates to refinance their debts. This time countries will have to rely on their economies, as opposed to the ECB, which will be problematic.
The European governments and the ECB didn’t solve the debt crisis, all they did was postpone it by printing currency and lowering short-term rates. The difference between now and then is this time there will be less tools available to prevent governments from going bust. If you really thought the Eurozone debt crisis was over, wait until part 2 reveals itself.
While there is increased risk of volatility and downside, the ECB has a long ways to go until its Japan: