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Fixed-Income Insights

The European Central Bank’s extraordinary stimulus moves could have a significant, longer-term impact on markets around the globe—especially that of the United States. 

 

In Brief

  • The European Central Bank (ECB) announced a series of dramatic policy moves on March 10 (see list below).
  • In addition to further reductions in benchmark interest rates, the ECB expanded its securities purchase program, broadening the scope of its quantitative easing (QE) effort to include non-financial corporate bonds.
  • While the moves should help spur economic growth and support asset prices in the Eurozone, the effects could spill over into markets elsewhere.
  • In particular, the United States could benefit as yield-starved global investors take advantage of its higher interest rates and as U.S. corporations see reduced borrowing costs.
  • The key takeaway—The spillover effects of aggressive QE purchases by the ECB could support global investments overall, with the United States being one of the prime beneficiaries.

 

The policy moves announced by the European Central Bank (ECB) on March 10 easily exceeded investor expectations. While characterized by many as “a bazooka shot,” the ECB’s actions are much better interpreted as a well-designed, multi-faceted strategy capable of achieving several different objectives. The policy changes listed below have the potential to enhance eurozone credit creation, promote growth without devaluing the euro, and improve appetite for risk assets in Europe, the United States, and globally. The ECB’s combination of policy moves may be the most creative test yet of the limits of monetary policy.

 

March 10 ECB Initiatives

  • The deposit rate was cut, from -0.30% to -0.40%.
  • The benchmark interest rate was lowered, from 0.05% to 0.00%.
  • The marginal rate was reduced, from 0.30% to 0.25%.
  • Quantitative easing (QE) was increased, from €60 billion to €80 billion a month.
  • QE was expanded to include non-bank corporate bonds.
  • A new series of four-year refinancing operations (TLTROs) was announced.
 

Investors expected the ECB to encourage bank lending by charging banks more for excess deposits and by making investment in government debt, even more unattractive through additional quantitative easing (QE) purchases. By themselves, these policies carried the risk that bank profitability would be hurt and lending might not increase, raising investor concerns about the sector and helping to lower the value of the euro.  While a lower euro might help spur some growth through increased exports, a weaker financial system and a potential contraction in credit could have evolved as an unattractive counterweight. A weaker euro could also beget competitive currency responses from European trading partners, such as China.

Fortunately, the ECB’s combination of policy initiatives seems designed to produce a more favorable outcome. The bank deposit rate was cut, from -0.30% to -0.40%, increasing banks’ costs, but the rates at which banks can borrow—the benchmark rate and marginal rate—were reduced at the same time. More important for bank profitability, and critical for promoting lending, is that the ECB announced a new series of temporary, long-term refinancing operations (TLTRO II).  This series of four refinancing operations allows banks to essentially get paid for lending. Banks that exceed their lending benchmarks can get four-year refinancing as low as the deposit rate of -0.40%. As further aid to bank profitability, existing loans from the first phase of TLTRO can be refinanced at the attractive deposit rate as well. 

Although time will tell, it seems that ECB policies could promote additional lending, which could spur economic growth, improve the health of the eurozone financial sector, brighten the outlook for risk assets, and forestall a euro-initiated currency war with other major global economies.

Cue the QE
In addition to indirectly influencing asset prices through lending and growth, expect other ECB policies to directly boost asset prices. The increase in asset purchases, from €60 billion to €80 billion per month, under the ECB’s QE program seems destined to push prices of even more European bonds to the point where yields are negative. 

The new policy decision to expand such purchases to include non-financial corporate bonds now extends the central bank’s direct impact on asset markets. Given the relatively small size of the European corporate bond market, even a modest amount of ECB purchases can have an outsized influence on security prices.  Credit Suisse estimates, for example, the available universe of euro-denominated investment grade non-financial corporate debt at €525 billion. If the ECB spends only €10 billion of the amount it spends, €80 billion per month, purchasing corporates, the central bank will own more than 20% of that sector within less than a year.

A more striking illustration of the potential impact of ECB purchases of corporate bonds is a comparison to net new issuance. The ECB reports that over the past 10 years, net new issuance of non-financial corporate bonds averaged €3.8 billion per month. Over the past three years, it averaged €3.7 billion. Investors who witnessed the powerful impact of persistent ECB purchases over the past year may anticipate not only additional impact on government securities but also on corporates as well.

Ripple Effects
U.S. companies may benefit as well.  Apple and Berkshire Hathaway are two recent examples of corporate borrowers tapping the eurozone credit market just before the ECB’s recent moves. With prospective rates even lower, we expect more U.S. companies to follow suit. While debt of non-European companies will not qualify for purchase by the ECB, such debt will still benefit from the lower rate environment. Further, the issuance of euro-denominated debt by U.S. companies may remove supply of corporate debt from the U.S. markets, and may promote European merger and acquisition activity with cheap financing. 

The ECB’s actions may have significant consequences outside the eurozone. Just as the U.S. Federal Reserve’s QE purchases were believed to influence asset prices elsewhere in the world, we expect the same spillover effect from the ECB. Yield-starved investors, as well as those who have had portfolio holdings purchased by the ECB, are likely to seek attractive returns elsewhere. The yields and liquidity of U.S. fixed-income markets, from investment-grade to high yield, seem likely beneficiaries. 

Investors who believe that greater strength in Europe should beget improved global growth may be comfortable diversifying into select emerging markets. And to the extent European growth expands without significant weakness in the euro, U.S. equities likely will benefit from increased investor interest in risk assets, along with mitigating U.S. dollar strength that compromised U.S. profits in 2015.   

Summing Up
With the traditional tools of monetary policy seemingly employed to their limit, the ECB has constructed a creative combination of initiatives that hold the prospect for improved European lending and associated economic growth. A better economic environment brings with it the potential appreciation of risk assets. Add an expanded QE program, and the scope of the potential impact broadens to include asset classes and markets around the globe. The spillover effects of aggressive QE purchases by the ECB could support global investments overall. But we think investors should pay particular attention to one indirect beneficiary of the ECB’s actions: the United States. The relative safety, market liquidity, and currency strength associated with the United States leave U.S. investments uniquely positioned to benefit from the ECB’s actions.

 

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