A week before Mario Draghi disappointed a thoroughly spoiled market by “only” cutting the depo rate by 10 bps, “merely” extending QE by six months, and failing to boost the monthly rate of asset purchases under PSPP, we explained why the ECB is effectively chasing its own tail.
The argument goes something like this: as the market continues to price in further rate cuts, extensions of QE, and increases in the pace of PSPP bond buying, yields on core paper will be driven inexorably lower, quickly negating any benefit the ECB would have gotten vis-a-vis the expansion of the purchase-eligible universe of bonds.The only alternative is to do away with the depo rate floor altogether and thus lock in even greater losses for the central bank on its trillion euro, “held to maturity”, pile of EGBs. Absent that, the ECB is effectively forced to delay the expansion of PSPP. In short: Draghi, like Kuroda, is running out of bonds to buy and the ECB’s situation is complicated by the depo rate constraint. Each incremental purchase takes Draghi closer to the QE endgame at which point the bank will either be forced to buy riskier assets (like IG corporates or, gasp, stocks) or else concede defeat on the inflation target.
While the market might have been disappointed by the ECB’s “underdelivery”, it came as a relief for the Riksbank, the SNB, the Norges Bank, and the Nationalbank who are effectively forced to cut each time the ECB eases or risk seeing upward pressure on their respective currencies. That dynamic has led to a veritable race to the Keynesian bottom with Norway as the last man standing in terms of conducting monetary policy with rates above zero.
As we head into 2016, a number of questions remain. Is Draghi done or will sluggish inflation “force” the former Goldmanite - gun to his head - to expand PSPP and/or take the depo rate to -0.40% (or lower)? If the ECB does cut further but doesn’t adopt a two-tiered approach to the application of NIRP, will the SNB be forced to go “nuclear” and apply negative rates to depositors in order to mitigate excess pressure on the EURCHF cross (remember, because the SNB has different rules for the application of NIRP, ECB cuts tend to impact the franc more than other currencies)? Will low inflation force Sweden to cut further despite a frightening housing bubble? Can the Norges Bank afford to keep rates in positive territory given the continued plunge in crude prices? And on and on.
For those who enjoy pondering such things, we present the following excerpts and graphics from Goldman’s Allison Nathan who looks at where we stand now, and where we’re going in the year ahead.
* * *
From Goldman
Where we stand
Official interest rates have fallen further in the Euro area and Sweden. The European Central Bank (ECB) lowered its deposit facility rate 10bp to -0.30% on December 3, pushing beyond levels previously described by Mario Draghi as the bank’s lower bound. The latest ECB measures fell short of market expectations, likely reducing the pressure for neighboring central banks to add stimulus; the Swiss National Bank (SNB) and Riksbank have subsequently been on hold.
Sweden’s Riksbank has been the only other central bank to push rates further into negative territory since we published in February, with cuts of 15bp in March and 10bp in July motivated by appreciation pressures on the krona. All the while, inflation—the Riksbank’s original reason for introducing negative rates—has been rising.
Government bond yields remain in negative territory. As of December 14, over 50% of European government bonds maturing in less than five years had a negative yield, roughly the same as in the run-up to the launch of ECB QE in March. Two-year government bond yields were generally lower on the year, despite some rebound after aggressively pricing further ECB easing ahead of the December meeting. (The German two-year yield, for example, bottomed out at -0.44% on December 2.) Looking beyond Europe, roughly half of two-year government bonds in the developed world trades at a negative yield.
Sovereigns have issued debt at record-low—or altogether negative—yields. In April, Switzerland became the first country to issue 10-year government bonds at a negative yield; other governments did the same at shorter maturities.
By contrast, companies with large pension deficits have struggled and continued to underperform, as the present value of their future liabilities continues to rise. Alongside mixed asset returns, pension funding ratios have continued to deteriorate. Similarly, insurance companies have struggled with falling reinvestment yields and solvency ratios.
Where we’re going
Risks that could push the ECB’s lower bound. While our base case is for the ECB to stay on hold, low inflation or a stronger euro could open the door for further monetary easing. We see the ECB’s effective lower bound in the ballpark of -0.50%. Should the ECB cut rates further, it would likely pressure neighboring economies in Europe to do the same or to implement other easing measures, particularly in cases where the local currency is pegged to the euro.