At Thursday’s meeting, the European Central Bank (ECB) ticked all the boxes that PIMCO was expecting and more: liquidity via targeted longer-term refinancing operations (TLTRO), rate cuts and asset purchases.
The challenge facing the ECB was how to ease further without hurting banks. Thursday’s decisions cautiously, and successfully in our opinion, rose to this challenge by ameliorating the deleterious impact that negative interest rates tend to have on banks. ECB policymakers are well aware that a central bank needs a well-functioning banking sector for monetary policy to work properly. While the ECB cut the deposit facility interest rate to -0.4%, it offset that by allowing banks to borrow via the TLTRO at rates as low as -0.4% as well as by lowering the interest rate on the main refinancing operation to zero.
The ECB’s decisions sent three signals. First, negative interest rates as a tool of monetary policy are effectively exhausted. Second, asset purchases and credit easing will do the heavy lifting of policy stimulus going forward. And third, the ECB is focused on the domestic credit channel to kick-start growth rather than lowering the euro.
While the ECB has yet to provide details on its expanded purchase programme, our initial thoughts are that it will purchase about €4 billion in non-financial corporate bonds per month. By adding corporate bonds to its list of government, agency and covered bonds as well as asset-backed securities, the ECB is now firmly in the realm of credit easing.
Although we acknowledge the marginal efficacy of monetary policy is declining, we disagree with the view the ECB has run out of ammunition. There remains a large amount of assets outstanding that the ECB could theoretically purchase. And now that it has started with corporate bonds, blue-chip equities are not a far step away, if ever needed. We concur with President Mario Draghi’s response to the question about helicopter money: We think the ECB is a long way from contemplating forms of monetization, and if history is any lesson, investors aren’t keen on monetization, either.
Eurozone markets finished the day mixed: higher government bond yields, marginally higher inflation expectations, a stronger euro, tighter credit spreads and lower stock prices. We think the reaction in the rates market has more to do with the signal that interest rate policy is exhausted. We do not think it is a signal that the phase of low growth and inflation is over.
The ECB’s inflation forecasts of 0.1% for this year, 1.3% in 2017 and 1.6% in 2018 are a sobering reminder more stimulus might be needed. The economic recovery remains vulnerable to negative external shocks, and we would not be surprised if more easing were needed.
The ECB’s decisions Thursday do not ease the challenges facing investors seeking yield and income. We think they will reinforce the focus on peripheral government, investment grade corporate and high yield bonds, reinforcing the need for careful credit analysis. The eurozone private sector is still deleveraging and banks need to dispose of their non-performing loans. For active investors, this constitutes an opportunity.