The European Central Bank’s one-two punch in June took activist central banking to a whole new level. Not only did it make history by setting the interest it pays on bank deposits below zero, but it has also introduced a new scheme — the TLTRO (Targeted Long Term Refinancing Operation). Under this scheme, a bank can borrow as much as three times its existing net lending to businesses, for a four-year period at roughly 25 basis points. In other words, a lot of money, at very little cost, for a long period of time.
These are radical moves, aimed at warding off deflation by cheapening the currency, cheapening the cost of funding and spurring on growth. Activist central banking may not quite achieve its economic objective, but it can have a dramatic effect on markets. So, what are the likely impacts?
First and foremost, the move to negative deposit rates signals that the ECB clearly has the euro in its sights. By setting interest rates below zero, the ECB has opened up the possibility that rates could be taken further negative, should the euro remain strong: a powerful signal that should keep the euro weaker.
Second, the ECB’s TLTRO is akin to the UK’s Funding for Lending scheme, only much bigger and on much better terms. The impact of this can be very powerful: while the TLTRO dramatically lowers the cost of long-term funding for net new loans, its effects will be felt more broadly because banks can borrow at a multiple of three times their new loan book. In other words, this massive injection of cheap funding should increase lending to all non-financial companies, big and small, including property companies across Europe.
Moreover, given that the ECB is willing to lend up to 7 per cent of a bank’s existing loan book, there is a powerful incentive for all financial institutions to take this cheap funding and reach out for yield — or play the carry trade. While this is contrary to the ECB’s objectives, it might very well be one of the unintended consequences. So, on balance, we expect the ECB’s liquidity deluge to compress yields for European bonds and real estate and reflate asset prices more broadly.
Third, after many years of synchronised cycles, country divergences are starting to emerge. The ECB is embarking upon expansionary and experimental policies at precisely the same time as the US Federal Reserve and the Bank of England are actively considering the timing and execution of their monetary policy normalisation (ie preparing markets for the end of the zero interest rate policy). This is leading to marked differences in monetary policy across the major economies.
Loose policy in Europe should lead to a weaker euro and lower yields, while expectations for tighter monetary policy in the US and UK should lead to stronger currencies and higher yields.
Fourth, the ECB’s aggressive liquidity measures should underpin risk assets globally. At the start of the year, there was a growing concern that an improving US economy would lead to a withdrawal of global liquidity and raise the global cost of capital. The emerging markets were particularly vulnerable to this reset in rate expectations — and as global capital gushed out of their relatively thin markets the accompanying volatility led to fears of a balance of payments crisis in many economies.
The ECB’s latest liquidity thrust should defer, if not allay, many of these concerns. There is unlikely to be a sudden jerk upwards in global interest rates, especially with the ECB’s sub-zero drag. Instead, cheap money from the ECB is likely to flood the world’s capital markets even as better US growth starts to lift global economic momentum. In such an environment, risk-facing assets are sure to benefit.
Finally, while aggressive central bank measures are certainly beneficial for risk assets, they carry with them longer-term risks. Extended periods of low interest rates can lead to excessive risk-taking, especially if investors, businesses and households start to embed ultra-low interest rates into their projections for the future.
But while longer-term risks may be gathering, the current environment of negative rates, cheap funding and an improving economy has become more supportive of risk assets. In this ‘new normal’, investors should feel confident that central banks will stop at nothing to support the global recovery and reflate asset prices.
Subitha Subramaniam also contributed to this article