Global economic growth has been slow and inflation has been stubbornly low despite efforts by central banks to raise them. The first round of unconventional policy involved central banks buying bonds and other assets and increasing their balance sheets. The strategy has only been moderately successful and is probably at the point of diminishing marginal returns. Therefore, an alternative unconventional policy had to be implemented: negative interest rates.

It is hoped that negative interest rates would encourage more credit creation to spur growth and inflation. What central banks would prefer markets to focus on less is the expected impact on currencies lest they are accused of waging currency trade war. Negative rates might also encourage investors further up the risk spectrum to taking more risk and reducing borrowing costs across a wider swathe of the economy.

There are a number of problems, however, with negative interest rates. First of all, it assumes that the problem stems from weak supply of credit. Low equilibrium interest rates are indicative of poor demand for credit, not deficient supply. Lowering the cost of credit is of limited impact in raising the demand for credit which depends more on the available unlevered returns in asset markets today, which looks quite meagre, as well as the prospects of paying down debt in the future. If economic prospects are poor, increasing the supply and lowering the cost of credit is unlikely to spur lending.

Negative rates are also confounded by banking regulation. Central banks and regulators have two conflicting missions for banks, make more loans and take less risk. Banking regulation highlights the fact that banks lend not out of liquidity but out of capital, and therefore the calculus for increasing the supply of credit is not entirely the cost of the bank’s credit but the cost of its capital as well. Cutting rates into negative territory helps with one part of the equation but is nullified by the other. Negative rates pay banks to borrow from central banks and to lend cheaply to borrowers. However, the type of borrowers central banks would like banks to lend to are small, medium enterprises, businesses too small to access bond markets. Unfortunately, loans to these types of borrowers consumer more capital under Basel III regulation. Banks have to apportion more capital against these loans which makes the cost of capital more relevant to the bank than cost of liquidity, which carries the negative interest rates. Cost of capital is a more comprehensive measure of how much it costs to make a loan and this is not directly addressed by simply cutting interest rates below zero.

Meanwhile, negative interest rates have some less desirable side effects. For one, it encourages cash hoarding. While individuals might be expected to engage in cash hoarding it was instructive to see Munich Re, one of Europe’s largest reinsurance companies engaging in storing physical cash in vaults. Negative interest rates could, perversely, result in a shrinking of the money supply.

Negative interest rates are damaging to the savings industry, in particular insurance and pensions. Insurance companies have long term liabilities which have to be funded. With ultra low interest rates and low asset returns, assets maturing face a lower expected return. Most insurance liabilities, however, are not benchmarked to interest rates and many have a guaranteed floor on returns. Negative rates threaten the long term solvency of the insurance industry. The same calculus applies to pensions, especially defined benefit schemes which guarantee a certain level of payouts unrelated to the returns generated by their assets.

A more insidious way that negative interest rates undermines the economy is that interest rates represent a hurdle for investments as well as a tide for the economy to swim against. A certain level of interest rates is also useful in eroding excess capacity and euthanizing unviable businesses. Human enterprise thrives on hardship to innovate and evolve. Nothing destabilizes like a tide from the rear. It is the life support that keeps inefficient businesses alive, maintains excess capacity and ultimately weakens the economy as a whole.

Negative interest rates.

Hmmm. I’ve seen this kind of liquidity provision before…

Now I remember!

Policy:

In December, the ECB extended QE from September 2016 to March 2017. Markets did not think it was sufficient, spreads between peripheral bonds and bunds widened, the EUR strengthened and equity markets sold off.

In late January the BoJ cut rates into negative territory and was rewarded with a stronger JPY and weaker equity markets, and the equivalent of a coronary in its money markets. Fortunately, not all was lost and JGBs rallied.

Last week the ECB was given a second chance to demonstrate determination and did so by cutting rates, increasing QE by 33%, including non-financial corporate IG to the shopping basket, and another dose of TLROs. Markets were skeptical at first but seem to be warming to the measures. This is the 3^rd trading day after the announcement and markets are buoyant so only time will tell.

Tomorrow, the BoJ will announce its policy decisions. It is hard to see what it can do to boost markets. Evidently it can do nothing for the economy.

On Wednesday the Fed announces its decisions and publishes an update on the dot plot. The American economy is robust despite being in a shallow, temporary and controlled slowdown. On domestic data alone, a data dependent Fed would raise rates. The Fed is, however, unwilling to unnerve investors since their behavior impacts market interest rates and credit spreads and is therefore a Fed control variable. The Fed has not signaled strongly that it will act and therefore will likely delay the rate hike into the summer. Hopefully, the USD will be sufficiently weak, equities sufficiently buoyant and spreads sufficiently tight for the Fed to play catch up.

At some stage all these central banks are going to have to start thinking about what they can do for the real economy.

The ECB’s moves were largely expected except for the inclusion of corporate debt on the shopping list. This should at least put a floor under the Euro IG market. The details, however, have not been released so we don’t know what the total or country allocations might be.

The ECB’s best policy has always been its LTRO. Its first incarnation, a 3 year unconstrained program, turned the ECB effectively into a pawnshop. It achieved a number of things:

1. Banks bought government debt when the ECB could not. The ECB had co-opted the banks into its QE. Call it, proxy QE.

2. National banks bought their respective national debt thus unwinding current account deficits very rapidly.

3. Coupled with a rate cut, the ECB provided banks with a profitable business, good for 3 years, consuming no capital. The profits would recapitalize the banks to some degree.

4. Governments’ borrowing costs fell.

The subsequent TLTROs were less effective. Why?

1. Private enterprise is unwilling to borrow. That’s it. The TLTROs were extendable only if the banks were seen to be pivoting their loan books to SMEs and private obligors. These LTROs were not meant for government bond purchases.

2. As one hand of the ECB provided liquidity to fund private loan growth, the other hand increased capital requirements. This placed banks in an untenable position.

What about the latest TLTROs?

The details are still patch but basically, the repo rates are zero with a discount available for compliant banks, banks with a willingness to engage in more active private lending. At a fully discounted rate of -0.4%, the ECB is basically paying the banks to lend. In effect, it is co-opting the banks to grow their loan books. Will it work? Basel III and TLAC rules still hold which will continue to constrain the banks. Assets tendered in repo are not a true sale. And for all these technicalities, demand for credit is simply weak.

The Eurozone economy has weakened in 2016 slipping into deflation with both manufacturing and services PMIs turning south in January and February. After disappointing the market in December 2015 with a mere 6 month extension of the existing QE the ECB will be expected to do more to spur demand and head off deflation.

The market will expect the following:

1. 20 basis point rate cut to take the deposit rate to -0.5%.

2. Additional 10 billion EUR monthly budget for bond purchases.

3. Program extension from Mar 2017 to Sep 2017

4. Additional TLTRO

What might not be effective:

1. A rate cut is not likely to be effective. The problem is not willingness to lend but willingness to borrow. Banks will not be able to pass on the lower rates while incurring costs on their reserves on deposit. They might well raise interest rates to make up for the additional costs.

2. The bond purchases are allocated according to the capital key which means 25.6% of the budget goes to German bunds, 20.1% to OATs, 17.5% to Italian bonds and 12.6% to Spanish bonds. Deflation is worst in Italy, Spain and France. Germany has zero price growth. The money is not going to where it is needed most.

3. TLRO take up has been disappointing.

4. Most of what the ECB can do, the market expects the ECB to do. There is no latitude for shock and awe left.

What might the ECB do to surprise the market?

1. Moving away from the capital key and allocating the budget to the countries which need stimulus most and trying to bring rate convergence between countries’
   bond yields could be more effective and would be taken positively by the market.

2. Currently the ECB buys 8% of the budgeted bond purchases, while the National Central Banks buy a further 12% under a risk sharing program. The other 80% is not commingled and each NCB bears the default risk of their own government’s bonds. The ECB could make all purchases risk-shared. This would pull peripheral and core spreads together bringing down interest rates in Italy, Spain and Portugal.

3. Removing limits on buying debt yielding less than the deposit rate. If the ECB cuts rates by 20 basis points, this point would be academic.

What might get in the way?

1. On Feb 25, 2016, Jens Weidmann, President of the Bundesbank, argued that his Eurozone counterparts are putting too much emphasis on recent weak data. The Bundesbank’s own prognosis for the Eurozone economy was less gloomy. This could be a signal that the Bundesbank, the largest capital contributor to the ECB, is unwilling to do more.

2. Draghi himself might decide that doing more of the same is not rational given that the initial program has not been effective. As long as the ECB was strenuously fighting deflation, governments would be less inclined to pursue fundamental reform.

Speculation.

1. If the ECB simply meets market expectations, it is likely the market will be disappointed.

2. The ECB has little room to surprise the market since the market is expecting a lot.

3. Draghi may, if he so chooses, openly speculate about going off the capital key, or commingling the NCB’s risk, to present the Bundesbank a fait accompli at the Apr 21 meeting.

Trades:

1. The EUR is fundamentally weak,  recent strength being related to the risk of a disappointing ECB announcement. The EUR remains a good short, however, the degree of uncertainty surrounding the Mar 10 ECB meeting recommends moderating this exposure.

2. Under TARGET2, countries are essentially risk-shared and as such peripheral bonds should trade tighter to German and French government bonds. Convergence trades are still rational. Again the uncertainty around the possible outcomes leads us to defer this trade until we have more visibility.