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Fixed-Income Insights

Here’s how the central bank’s radical new policy initiatives—including negative rates on bank deposits—could impact investors in the United States, Europe, and elsewhere. 

 

In Brief

  • Four policy moves by the European Central Bank (ECB) on June 5 are designed to forestall deflation, weaken the euro, and promote lending to small businesses.
  • The moves include a reduction in the ECB’s benchmark interest rate to 0.15%, a reduction in the deposit rate it pays banks to -0.1%, an end to the sterilization of bond purchases under its Securities Market Programme, and an incentive to encourage bank lending.
  • The four initiatives, as well as the prospect of asset-backed purchases and possibly quantitative easing, seem to signal lower interest rates in the eurozone.
  • The key takeaway: The ECB’s policies could make European fixed-income investments and deposits less attractive. A weaker euro could provide further incentive for global investors to seek opportunities elsewhere. 

 

The four-pronged policy initiative announced by the European Central Bank (ECB) on June 5 is designed to prevent the eurozone from slipping into a deflationary environment, weaken the euro, and promote lending to small businesses. This move will hopefully produce stronger European economic growth in the process. The new policy also will have consequences for European investments as well as those in the United States and elsewhere. 

Longer term, growth expectations related to eventual economic success of ECB policies will be reflected in equity prices. In the near term, the ECB initiatives could combine to pressure European interest rates lower and, as a consequence, restrain the rise in U.S. interest rates that should accompany stronger U.S. growth, the Federal Reserve’s ongoing tapering efforts, and a gradual rise in U.S. inflation.

The ECB package can be characterized as both extraordinary and overdue. It’s extraordinary in the design of its components and in the breadth of their expected collective impact. It’s overdue because the European economy has struggled for positive growth over the past five years, while the United States, which adopted its own set of unprecedented policy measures in 2008 and 2009, has been able to achieve roughly 2% annual growth over the last several years. 

It took the fear of deflation, provoked by the release of a Eurostat report on June 3 showing 0.5% annual eurozone consumer price inflation in May, to prod the ECB into action.

Unfinished Business
The ECB policy initiatives include a reduction in its main intervention rate to 0.15%; a reduction in the deposit rate it pays banks to negative 0.1%; an end to the sterilization of bond purchases under its Securities Market Programme (i.e., various short-term measures to drain funds from the financial system to offset the additional liquidity provided by the asset purchases); and an incentive to encourage bank lending. The ECB is also examining a program to purchase asset-backed securities and is considering its own form of quantitative easing. So, it seems that there is a promise of more to come. As Draghi said to the press on June 5, "Are we finished? The answer is no."1

While there is more to come, we can expect investment consequences from what has already been announced.  Equity investors likely will gradually and continually assess the collective success of ECB policies in stimulating growth in Europe. The fixed-income market may also respond to the ECB’s success in achieving economic growth. An examination of the investment impact of each component of the ECB’s announcement is appropriate:

1) Reduce the benchmark rate to 0.15%.
While marginal, the 10 basis point reduction in the ECB’s benchmark rate reinforces the ECB’s commitment to significant and sustained monetary easing. The near-zero interest rate policy should pull short-term interest rates slightly lower. Longer-term interest rates likely will also be influenced lower as investors perceive the ECB’s increased commitment to low rates. Lower yield curves within European countries could begin to influence global investors, who may increase their preference for higher-yielding alternatives outside Europe. As a result, the euro could weaken, providing investors further incentive to look elsewhere, perhaps to the higher-yielding U.S. or even emerging markets. 

2) Cut the bank deposit rate to -0.1%.
Charging eurozone banks to hold deposits at the ECB should provide incentive for the banks to instead lend those monies, but other consequences seem likely. Instead of lending, which may be compromised by banks' concerns with existing bad debt and sluggish demand from worthy creditors, financial institutions may instead invest in other short-term alternatives. Expect European money market investments to yield less as banks find that zero interest or even a slightly negative rate on short-term investments may be preferable to losing 10 basis points on a deposit at the ECB. 

Lower money market and short-term rates may cause even greater financial repression in Europe as investors face pitiful returns on short-term, higher credit-quality investments. Banks will be in position to offer zero rates, or possibly negative rates, to depositors for fear of compounding their negative rates problem with the ECB. The ECB and equity investors must hope that financial repression provides sufficient disincentive for saving, and instead prompts spending that results in economic growth.

3) End the sterilization of bond purchases.
Ending the ECB’s sterilization of bonds purchased under the Securities Market Program should essentially provide additional funds to the banking system. While it is hard to quantify the interest-rate impact, the additional funds associated with about €150 billion remaining in the program will exert downward pressure on rates as the ECB stops withdrawing funds created by their securities purchases. Once again, shorter-term securities may feel the greatest impact. The end of sterilization seems like a dress rehearsal for broader asset purchases, a potential ECB action that has been discussed but not executed.

4) Provide additional lending incentives.
The ECB’s "targeted long-term refinancing operations" (TLTRO) hold great hope for inexpensive financing to reach small businesses to create jobs and promote growth. Under the €400 billion program, banks can borrow three times the net increase in qualified loans at a rate of 0.25% for up to four years. Such attractive financing, for a four-year period, has fundamental appeal. The ECB, economists, and equity investors all hope for the desired result: increased lending, more jobs, a stronger economy. However, the European banks in peripheral nations such as Greece and Italy, where such lending is needed most, remain saddled with poor-performing loans, lack of capital, and upcoming stress tests later this year. 

Given some reluctance to add to a portfolio heavy with bad debt, banks may instead take advantage of the program to borrow funds inexpensively and invest in short-term securities rather than lend those funds to small businesses or individuals. This scenario may have validity, because under this program, banks could begin borrowing in September 2014, and if the use of funds does not comply with the ECB’s lending requirements, the banks will have to repay borrowed monies in September 2016 rather than September 2018. They will at least have access to the funds for two years, apparently without penalty or consequence.

Once again, the hope is that the program succeeds in financing small-business expansion, but it seems likely that some monies will find their way to short-term securities, bidding up prices, and reducing rates.

Investment Implications
The intent of the ECB’s initiatives is to weaken the euro, promote economic growth, and promote inflation.  Individually and collectively, a consequence of the four initiatives, as well as the prospect of asset-backed purchases and possibly quantitative easing, seems to be almost unavoidably lower interest rates.

The four initiatives that have been announced seem likely to have their greatest impact on shorter-term securities.  But as we have seen in the United States, such movements can affect rates for longer-term securities as well. The prospect of purchases of asset-backed bonds by the ECB and the possibility of quantitative easing, if they resemble similar programs in the United States, could have a more direct effect on securities with maturities beyond five years. To the extent the ECB’s policies make European fixed-income investments and deposits less attractive, the euro could weaken, providing further incentive for global investors to seek opportunities elsewhere. 

Thus, even in the United States, the ECB’s moves are likely to have some impact. Depending on how quickly these policies are deployed, global demand for U.S. fixed-income securities seems poised to increase, especially as the 10-year U.S. Treasury note yields substantially more than comparable German bonds, and about the same as the Spanish 10-year government bond, according to Bloomberg.

It seems unlikely, however, for this additional demand to completely offset the combined impact of the Fed’s complete exit from quantitative easing (likely in October 2014), a gradual improvement in U.S. economic growth, and a gradual increase in U.S. inflation. Thus, the expected rise in interest rates in the United States may be slowed by consequences of ECB policy, but not stopped or reversed.

It is worthwhile also to keep in mind that the ultimate goals of the ECB’s policies as well as those of the Fed and the Bank of Japan are for higher inflation. Investors need to be aware of the immediate consequences of ECB policies. And some investors may wish to pursue short-term strategies that can capture opportunities created by ECB policies. But for the longer term, investors in Europe, the United States, and elsewhere are wise to remember a more current take on the time-honored adage warning about fighting central banks—no matter their geographic location.

 

1Peter Coy, “'Are We Finished?' Asks European Central Bank Chief. 'The Answer Is No,'” Bloomberg BusinessWeek, June 5, 2014.

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver a high level of current income consistent with the preservation of capital by investing primarily in a variety of short duration investment grade and high yield debt securities, U.S. government securities, and mortgage- and other asset-backed debt securities.

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