Policy Matters

European Central Bank Action

John L. Bellows
Portfolio Manager / Research Analyst
Andrew Cormack
Portfolio Manager

On June 5, the European Central Bank (ECB) acted aggressively to provide more liquidity to the eurozone. Below are notes on the two most important parts of the ECB announcement: negative deposit rates and the new Targeted Longer-Term Refinancing Operation (T-LTRO) program.

NEGATIVE DEPOSIT RATES: The ECB lowered the deposit rate to -10 basis points (bps). While this was important as a symbolic step, the immediate impact of negative rates is likely to be limited.

    WHAT: The deposit rate is the rate that banks earn on excess reserves that are held at ECB. A negative deposit rate means that banks will now be charged for holding excess reserves at the ECB.

    IMPACT: While negative rates are significant—and unprecedented for a major central bank—there are at least two considerations that will limit the overall impact of negative rates. First, bank excess reserves have been falling over the past few years, so that the amount of reserves that are subject to the 10 bps charge is likely below EUR100 billion (for comparison, in early 2012 the number would have been EUR800 billion). Second, market rates are likely to settle somewhat above the deposit rate, which means that most lenders will not be facing negative rates for short-term loans. In particular, deposits at most commercial banks will still earn a positive, albeit very small, return on the balance. As long as market rates for short-term deposits stay above zero, the overall impact of negative deposit rates will likely be contained.

    MARKET REACTION: The negative deposit rates were largely expected by market participants. Somewhat unexpectedly, ECB President Mario Draghi said in his press conference that the deposit rate at -10 bps is now effectively the ECB’s lower bound. This was somewhat more hawkish than many were expecting. As a consequence, the EUR/USD exchange rate is actually unchanged over the past few days.

TARGETED LTROS: Perhaps more surprisingly, the ECB also announced a new program called “Targeted Longer-Term Refinancing Operations” (T-LTROs). This is a potentially very significant program that could increase bank liquidity, support European asset prices, and potentially lead to new credit creation.

    WHAT: The T-LTROs essentially provide European banks with very low cost loans for up to four years. The rate on the T-LTRO is set at the ECB refinancing rate prevailing at the loan inception plus a spread of 10 bps; currently the rate would be 25 bps, which is anywhere from 50 to 200 bps below where many of these banks would be able to borrow in the private market. In addition, the T-LTRO program has a series of incentives that are intended to encourage banks to make new commercial loans.

    IMPACT: We expect that many banks are likely to participate in this program. The rate on the loans is quite low and there does not appear to be much downside risk for banks that take these loans. As a consequence, participating in the T-LTRO program represents a potentially attractive opportunity for European banks to borrow at this very low rate and then reinvest the proceeds at a higher rate, earning a profit equal to the difference. However, it is less clear whether this program will lead to new credit creation in Europe. Credit creation has been slowed by lack of demand for loans and a shortage of bank capital, neither of which is addressed by this program.

    MARKET REACTION: The T-LTRO program was a surprise for many market participants. One immediate impact of the program has been to increase prices for peripheral debt—including Italian bonds—and especially for debt with maturities under five years. This reflects the additional provision of liquidity by the ECB, which will support carry trades in Europe and elsewhere. Other trades have also benefited, including emerging market bonds and certain corporate bonds.

EXPECTATIONS GOING FORWARD: While this announcement was clearly important, it is likely not the last move from the ECB. In particular, the ECB’s measures are still probably not enough to ensure inflation heads back to the inflation target over the medium term. Ultimately banks’ access to credit is one factor contributing to why lending to the real economy is so weak, but it is not the only factor. While these measures address some of the supply-side constraints, they do not directly address the demand side, which remains weak. We expect inflation dynamics to remain very subdued; hence, we do not rule out a full quantitative easing program later this year or in 2015. As a consequence, over the next few months, rates in Europe are likely to stay quite low. European yield curves should initially steepen then flatten out as short-dated yields fall to record low levels. Peripheral bond markets and other spread sectors should remain well supported.

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