‘Super’ Mario Draghi’s last policy initiative before stepping down as ECB chief was to start another round of asset purchasing, as well as cutting rates which were already in negative territory.
A lot has been said of the former head of the ECB, some reported that Sabine Lautenschläger, a senior member of the central bank’s council, stepped down in protest of loosening monetary policy further. Western Asset Management’s Andreas Billmeier is well placed to comment on ECB policy, an economist who once worked for the IMF and a sovereign bond analyst currently, his insights might be alarming for those hoping for an ECB-inspired European revival any time soon.
In terms of asset purchasing, or QE (quantitative easing), there have been claims of a ‘Japanification’ of the European bond market. Firstly, this is technically wrong, as Japan moved from QE to yield curve control a few years ago. The main difference here is that rather than just buying huge amounts of its own debt, the Bank of Japan set a target for its ten year bond yield and bought paper specifically to keep the yield at that level.
While bond traders have bemoaned that the move froze up the Japanese bond market (60 percent of the bonds are owned by the country’s central bank) it did steepen the curve, which is beneficial to bank profitability. Given the Eurozone is made up of individual countries with different ratings, yield curve control would be unworkable in a European context.
Mr Billmeier told Fundeye: “When the asset purchasing programme was also started again it was because inflation expectations by professional forecasters had dropped to an all-time low. When this happens things ‘de-anchor’ and the rest of the tool kit like rate cuts become ineffective.”
The ECB’s inflation target of 2 percent has not been reached and as Mr Billmeier has previously been quoted as saying, this is why Mr Draghi has ‘thrown everything but the kitchen sink’ at the problem.
Although QE may help in raising inflation, indeed before QE started inflation was hovering just above zero and two years into the programme broke above 1.5 percent, it has some bad side effects. The ECB is buying medium to long term paper, which is flattening the yield curve. If a yield curve is flat, it reduces bank profitability. The ECB came up with a way of helping banks, introducing a two-tier system exempting parts of banks’ excess liquidity from the record low rate of minus 0.5 percent.
It’s the above policy that Mr Billmeier believes the ECB will focus on going forward. “The hurdle to cut rates from here is quite high, higher than the US, we’ll see one or two cuts this year by the US but much harder to do by the ECB,” he said.
He added that rate cuts are not out of the question, if there’s a recession the ECB will be forced into doing it but it’s difficult to envision where to go from minus 0.5 percent. “If you have a problem with inflation you do more QE. Bank profitability, you increase the exemption coefficient on negative rates for reserves,” he eloquently summed up. This said he doesn’t foresee any policy changes until at least the second half of the year.
Personalities
With a new ECB chief in the form of Christine Legarde taking the helm, what does this mean for policy going forward? In some ways, Mr Draghi was a controversial figure, his inability to speak German was probably not going to win him many allies from the largest economy in Europe.
“Legarde’s presence is different to Draghi’s, he wasn’t very interactive. First thing that Legarde did was show up at the New Year reception of Frankfurt. Here’s a way of relating to your host which was under used [by Draghi],” said an impressed Mr Billmeier, himself a German national.
Some have commented on the fact that both Jay Powell and Ms Legarde come from legal backgrounds which may influence their policy making. Mr Billmeier is unconvinced that this is a factor.
“It’s not about educational background, It’s a personality issue. You can’t compare Legarde to Powell in regards of relating to people. However, if you not hardcore in the topic [economics], that might be relevant but it’s more about who’s around you and personality,” Mr Billmeier mused.
The impact of ECB policy on investment funds and asset allocation is well documented but worth a quick summary. Income investors were pushed up the risk spectrum by QE as yields in Eurozone sovereign bonds (followed by investment grade corporate bonds as the programme was extended) fell dramatically. Some firms have done well from this shift in investor sentiment, such as Rubrics Asset Management’s Global Credit Fund, information on which can be found here.
For equities, the old adage ‘a rising tide floats all boats’ seems apt as passive players enjoyed the liquidity boost which led to indices going up across the Eurozone. However, with practically all monetary policy tools being used, the ECB may be out of options and calls for fiscal solutions to Europe’s economic malaise will be a hard sell to political parties hoping to win power in their respective countries. With some suggesting that the Coronavirus outbreak may be the start of the big market correction that all fear, the sustained use of extraordinary monetary policy measures may come back to haunt Europe’s central bank, given we’re already at negative interest rates.
