New Monetary Easing by the ECB Has Many Hidden Dangers

by the Curmudgeon with Victor Sperandeo


Executive Summary:


On Thursday, March 10th the European Central Bank (ECB) announced a huge new package of financial measures to stimulate the Eurozone economy, with expanded quantitative easing (QE), incentives to banks to increase lending and further interest rate cuts in negative territory.  In particular:

·       The ECB cut its deposit rate by 10 basis points to – 0.4% with the intent to stimulate Eurozone lenders to increase credit to households and companies. 

·       The ECB also raised the amount of bonds the central bank buys each month (QE) from €60bn to €80bn — a greater amount than many analysts had expected. It also expanded the range of assets it will buy to include high quality corporate bonds. 

·       The main refinancing rate was also cut by 5 basis points to 0%.

·       Four targeted longer-term refinancing operations (TLTRO II), which will offer attractive long-term funding conditions to banks to further ease private sector credit conditions and to stimulate credit creation (see Victor's comments below).


ECB President Mario Draghi said interest rates would stay low for “an extended period” and he kept open the option of a further cut.  He also expressed concern about negative rates among top central bankers, saying he did not anticipate pushing deeper into negative territory, partly because of the negative impact on banks. 


“Does it mean we can go as low as we want without having any consequences on the banking system? The answer is no,” Draghi said.  To help Eurozone banks, it will provide liquidity through targeted longer-term refinancing operations, with rates as low as minus 0.4% — in effect paying them to borrow money.


Not all ECB policymakers backed the package, which included cuts to all the central bank’s benchmark interest rates. The vote was 19 to 2 in favor, with dissenting votes cast by the head of the Dutch central bank, Klaas Knot, and Sabine Lautenschläger, the German member of the ECB governing council.


The ECB slightly cut its macroeconomic forecast. The ECB cut its GDP forecasts for 2016 to +1.4% from +1.7% and for 2017 to +1.7% from +1.9%.  The central bank sharply downgraded its inflation forecast to 0.1% this year, from the 1% it had predicted in December. Mr. Draghi said it was “crucial” to avoid very weak inflation taking hold across the economy.


Financial Times (FT) Analysis:


Central bankers were once celebrated as the miracle workers of the global economy, but many people wonder whether they have lost their magic powers.  Central banks’ efforts to save the global financial system from collapse might have worked but, despite ultra-loose monetary policy, growth and inflation remain weak and in the Eurozone unemployment remains painfully high.


The ECB’s big idea to silence the doubters is an auction of their cash that will, if it works, in effect involve central bankers paying banks to lend to businesses and households. Policymakers are praying these auctions, dubbed Targeted Longer-Term Refinancing Operations, or TLTROs, will finally produce the meaningful recovery that the single currency area craves.


“The ECB has designed its suite of measures to have the most impact on activity,” said Karen Ward, chief European economist at HSBC Investment Bank. “[It] has changed the emphasis of its actions from depressing the exchange rate and relying on external demand and higher import prices to trying to fuel the domestic recovery by nurturing the banks to support credit growth.”


The idea of the auctions was presented by officials and the package was supported by all but four of the 25-member governing council in what Mr. Draghi described as “a very reassuring discussion.” Under the ECB’s system of rotation only two dissenters had votes this month.  The ECB will hold four auctions — one a quarter from June 2016 to March 2017. Banks can bid for cash of the value of as much as 30% of their loan book. At most, they pay nothing on the four-year loans, which they will not have to pay back until 2020 at the earliest. But if the banks lend more, then the ECB will pay them up to 0.4%t interest on the lenders’ loans with the central bank.  The big question is whether banks, businesses and households will take the bite?


Paying private banks to lend is novel, even for a generation of monetary policymakers used to rolling out shock-and-awe measures. Yet earlier designs of the TLTRO were touted as game changers and in the end proved much less effective than ECB hoped.


In a region drained of confidence, businesses and households might not want to borrow. Or banks could use the funds to invest in financial markets instead of expanding their loan books, pumping up asset prices but leaving the Eurozone economy flat.


“While [the new TLTRO] is clearly groundbreaking, it remains to be seen whether it will work,” said Carsten Brzeski, chief economist at ING-DiBa. He added: “The ECB is clearly determined to keep on fighting. Admitting impotence does not seem to be an option.”


Euro Whipsaw:


In one of the most volatile days in Euro history, the single currency fell nearly 1.5% Thursday as the ECB unveiled its wide-ranging package of monetary easing measures, only to reverse course and soar close to 2% higher above $1.12 per US dollar.  The trigger for the reverse appeared to be Mario Draghi’s press conference after Thursday’s announcement where the ECB president implied there was a limit to further negative interest rates.  Euro volatility continued on Friday, the single currency first retreating 0.75% to $1.1090, before rising back to $1.1176, the level at which it began the trading day.  At press time, the Euro was trading at $1.1157.


Victor's Comments - “PhD Standard” with a Twist:


The "PhD Standard.”  That's what James Grant (Grant's Interest Rate Observer) called QE monetary policy in October 2012.  It certainly applies to Draghi's extraordinary monetary measures announced on Thursday.   The ECB's bazooka moves are intended to increase Eurozone inflation, which I think is to reduce the debt of Europe. Of course, inflation is a hidden tax which also tends to reduce the exchange rate of the currency.


Few noted a critical twist in Thursday's ECB announcement: the ECB will PAY Eurozone banks 40 bps if they actually make loans with the free money from the ECB.


So it's actually not a -40 negative rate any more as the Eurozone banks will get paid more to do what they are in business to do in the first place!  Who will pay the ECB the money to transfer 40 bps to the banks? THE TAXPAYER!  The taxpayer doesn't get the bill right away; it is in the form of print fiat money or the hidden tax on the people.  This is an example of why I believe the financial system has to lead to economic collapse sometime in the future.


Who are the losers with these negative rates, besides the bulk of the people? The Pension Funds and Insurance Companies who do NOT get the 40 bps!


There is a crisis in the insurance business as the flat yield curve from the weak economy and negative interest rates are causing losses in the "whole life" insurance business. You can understand that the way insurance companies made money was to guarantee a 3.5% to 4% rates on “whole life insurance” policies, but then invest in Corporate Bonds at 5+%. However, the current yield on the DJ Equal Weight US Corporate Bond Index is only 3.25% (as per Barron's 3/14/16 edition, page M52). This is a small part of the collateral damage done by the 'PHD Standard."


Sidebar: Danger of Inflation Debauching the Currency:


From The Economic Consequences of the Peace (1919), by John Maynard Keynes:                                                                         


“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.”


This latter most important insight by Keynes, and what Central Bankers have accomplished is "...while the process impoverishes many, it actually enriches some." For example, the holders of equities for the last seven years has enriched the very rich, but has not benefited the man on the street.



Victor's End Note:


Let's end with a quote from the first and still the greatest U.S. Progressive (i.e. someone who attempts to undermine the Constitution) - Woodrow Wilson (page 49 of his New Freedom book):


"The government of the United States at present is a foster-child of the special interests. It is not allowed to have a will of its own." 


Today, “the special interests” are the bankers who own the FED!

Good luck and till next time...

The Curmudgeon


Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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