We recently wrote that we live in an age of central bank heroics. But so far it’s all talk from the ECB. As we can see from the table below whereas continued asset purchases from the Federal Reserve and those announced by the Bank of Japan have significantly increased the size of central bank balance sheets in the US and Japan since the start of the year, the balance sheet of the ECB has actually shrunk to 27% of Eurozone GDP from 32%, largely as a result of €276bn of LTRO liquidity being repaid1. Given on-going anaemic growth in the Eurozone and outright recession in southern Europe, ECB inaction to date compared with their peers is somewhat baffling.
*N.B UK and Japan based on announced purchases which may not yet be enacted
Source: Argonaut/Bloomberg, April 2013
Last Thursday, ECB cut its lending rate from 75bps to 50bps. We do not expect this action to have any significant effect on Euro money markets or the Eurozone economy as EONIA, (the main reference rate for commercial lending) is currently just 8bps1. In fact the only discernible effect of the rate cut is that banks borrowing from the ECB through the LTRO or ELA (mostly French and Southern European names) will be able to do so 25bps cheaper. Given that these banks are in general shrinking their customer loan books but not their assets, we can speculate that the “carry trade” by which Eurozone banks borrow money from the ECB to invest in their sovereign bonds just got 25bps more profitable. Windfall profits from this trade are however masking eroding net interest income (from declining volumes and shrinking margins) in their core retail banking franchises.
In his press conference Draghi commented that the ECB was considering a negative deposit rate. This would mean that commercial banks would pay to leave money on deposit at the ECB. There is currently €628bn on the ECB balance sheet of commercial bank liquidity2 for which this charge would be applicable (down from a peak of €1,148bn in March 2012)1. As such commercial banks with deposits at the ECB would be incentivised by a negative interest rate to put this liquidity to work or else suffer a hit to earnings. Although there is currently significant uncertainty as to the effect of a negative deposit rate, the ECB’s intention in introducing a negative interest rate is surely for deposit rich “core” commercial banks to directly lend their excess liquidity to deposit poor “peripheral” banks (rather than through the ECB as an intermediary at a penal rate). If the policy worked it would have a number of desirable outcomes from the ECB’s perspective: reverse the “balkanisation” of the Eurozone banking industry, decrease the ECB balance sheet size and risk, and establishing cheap market funding for peripheral banks (which could then be lent into the real economy of the peripheral economies stuck in recession).
It is however far from clear whether the policy would have this intended effect. It is not obvious that the peripheral banks would find attractive lending opportunities if their economies are fundamentally uncompetitive for reasons other than the absence of cheap funding. Conversely, the deposit rich banks may - instead of lending their excess liquidity to other banks - prefer instead to buy high quality short duration bonds with low but positive yields (government, corporate paper, covered bonds). This would push the hunt for yield further into riskier asset classes (and ultimately European equities).
Mario Draghi may be about to put on his superhero tights, but the consequences may be more positive for equity and bond markets than the real economy.
Founding Partner & Fund Manager
9th May 2013
1 Source: Bloomberg, April 2013
2 Source: ECB Balance Sheet, April 2013
ECB - European Central Bank
GDP - Gross Domestic Product
LTRO - Long Term Refinancing Operation
EONIA - Euro Over Night Index Average
ELA - Emergency Liquidity Assitance