Here’s a critical question for investors in Europe: Can the European Central Bank orchestrate a beautiful deleveraging? It is clear that bail-ins and
haircuts are likely to play a larger role going forward in reducing unsustainable debt burdens. This is not to imply the European Central Bank (ECB)
would ever contemplate monetisation, but rather to counter the view monetary policy is exhausted while acknowledging its declining marginal efficacy.
Critically, the extent to which bail-ins and haircuts occur depends on growth and inflation. Without the right mix of both, deleveraging can be an ugly
affair. A beautiful deleveraging occurs when ample nominal economic growth reduces a debt overhang to a sustainable level. Real growth supports the value
of collateral and generates cash flow to service debt; inflation lowers debt’s real burden. For bond investors, achieving the right amount of inflation is
crucial to a beautiful deleveraging. Too much erodes creditors’ purchasing power, too little renders debtors vulnerable to default.
Europe’s deleveraging is not looking pretty. The post-Lehman policy response averted deflation but the ensuing period has been scant on both growth and
inflation. Real national income, as measured by gross domestic product (GDP), has just returned to 2008’s level while nominal GDP, which includes
inflation, has grown by only 8% in aggregate, averaging just 1.1% per annum (see Figure 1). Debt levels remain elevated as a result, having increased in
the public and non-financial corporate sectors relative to GDP (see Figure 2).
Aging societies, debt overhangs and lack of productivity growth are common factors holding down economic expansion in many industrialised countries. With
an incomplete monetary union, the eurozone has additional idiosyncratic factors hindering its recovery.
The absence of a federal budget and high levels of government debt reduce fiscal capacity. The lack of federal deposit insurance blunts the full
pass-through of ECB monetary policy to member states. With growth stuck in low gear and rock-bottom policy rates, the eurozone is caught in a liquidity
trap. Time will tell whether the ECB’s latest stimulus package is enough to get the eurozone out of this predicament or whether it simply is pushing on a
string. Although its sobering inflation forecasts of 0.1% in 2016, 1.3% in 2017 and 1.6% in 2018 suggest more easing might be needed, what could the ECB
still do, and will it work?
Monetary policy phases
Before considering what the ECB could still do, it helps to get orientated on where we came from and what history suggests the final destination could be.
To do so, we divide monetary policy into a continuum of three phases: conventional, unconventional and monetisation.
Conventional: policy rate changes, liquidity provision, reserve requirements
Unconventional: negative interest rates, large-scale asset purchases
Monetisation: full subordination to fiscal policy, helicopter money
To state the obvious: The ECB is in the unconventional phase. We concur with ECB President Mario Draghi’s statements at the 10 March press conference that
its scope to cut interest rates further is limited. The benefits of even lower negative rates are declining and the costs are rising. In Draghi’s words,
“[Can we] go as negative as we want without having any consequences on the banking system? The answer is no.” Interest rates below -0.5% could ultimately
be counterproductive, in our opinion, for three reasons.
Negative interest rates reduce banks’ profitability because they lower net interest income. Interest income falls because banks typically pay zero interest
on retail deposits while paying the central bank on excess reserves and earning less interest on their overall loan book. The central bank’s negative
interest rate confronts commercial banks with a dilemma. Doing nothing impairs their profitability, with consequences for the cost of equity capital and
wholesale funding. Yet banks cannot pass on negative interest rates to retail customers, who can redeem deposits for cash yielding zero, for risk of
triggering a run on deposits.
Negative interest rates force banks to cut costs, raise revenues or find other ways to remain viable. One way is to raise interest rates on loans and
mortgages. Paradoxically, negative interest rates might lead to higher borrowing costs for consumers and businesses. Sweden’s Riksbank and the Swiss
National Bank cut their policy rates to -0.5% and -0.75%, respectively, yet banks in these countries increased mortgage lending rates relative to the
policy rate to improve profitability.
Negative rates work like currency intervention in disguise, which taken globally, is a zero sum game. By not passing negative interest rates on to retail
customers, banks shelter households’ savings and consumption behaviour from the incentives of paying to save. Banks pass negative interest rates on to
wholesale lenders, however, who cannot hoard large quantities of notes. Negative wholesale money market interest rates place downward pressure on the
external value of a currency. In large, open economies, negative interest rates export the central bank’s deflationary problem abroad via currency
With the interest rate on its deposit facility at -0.4%, the ECB has effectively exhausted interest rate policy. It could cut the interest rate on the main
refinancing operation, currently zero percent, a bit further, but if more stimulus were needed, we think it will have to expand asset purchases instead.
Obliged to be unconventional: credit easing
By adding corporate bonds to the list of government, agency and covered bonds as well as asset-backed securities that it is purchasing, the ECB is firmly
in the realm of credit easing. As we gain experience with large-scale asset purchases (LSAP) – quantitative easing using government bonds and credit easing
using private sector securities – we see two aspects that suggest they too have a declining marginal efficacy.
The first is the weak investment since the financial crisis. The most likely counterfactual to what would have happened without LSAP is a depression;
however, LSAP might simply be laying the foundation of the next bubble by stimulating financial investment instead of investment in the real economy.
Andrew Lapthorne at Societe Generale points out that companies in the U.S. have borrowed to finance stock buybacks, particularly since 2011, rather than
invest in the real economy (see Figure 3). Stock markets may become vulnerable once the monetary stimulus has been taken away.
The second is that despite LSAP, risk premia can still increase when fundamentals or technical market flows dominate, as the experience in the first two
months of this year suggests. We think the limited extent to which LSAP can compress credit and equity risk premia through purchases of government bonds
relates to the inelasticity of demand for high quality, perceived safe assets. As many of our clients know, there are limits to how much risk – term,
credit and equity – investors are prepared to take.
While many investors have expanded their risk limits in response to low yields, risk budgets still exist. Once reached, the known loss on low or
negative-yielding government bonds might be preferable for some investors to the potentially unknown loss, or gain, on riskier assets, particularly if the
central bank’s purchases drive the valuation of assets away from fair value. In other words, once the most elastic investors have sold out to the central
bank, LSAP could also end up pushing on a string.
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 non-financial corporate bonds, blue-chip
equities may not be far away.
To sustainably suppress credit and equity risk premia, however, we believe the ECB would have to buy similarly large quantities of corporate bonds and
equities as it has of government bonds. To be clear, this is not our forecast, but were more easing needed in the future, we think this is the route
unconventional monetary policy would take.
In their basic form, unsterilised purchases of assets are a modern version of ancient rulers debasing their currency. LSAP of government bonds enables a
government to finance the budget deficit. The line between a central bank buying newly issued government bonds in the secondary market or direct from the
government is very fine, yet critical, to whether the activity is monetisation or not. In the extreme, does it really matter whether LSAP of government
bonds occur in the secondary market or not?
You don’t want to go there: monetisation
Should unconventional monetary policy fail to pull countries out of the liquidity trap, the risk governments remove central bank independence and use
monetary policy to directly finance budget deficits is not to be underrated.
If economies remain stuck in a liquidity trap, for example, the amount of LSAP needed to sustainably achieve a 2% inflation target might be so large that
the boundary between indirect and direct financing of the budget deficit is indistinguishable. And once on that slippery slope, explicit monetisation of
the budget deficit – such as a direct line of credit between the central bank and the government – may not be far away.
The temptation to monetise might be most acute in societies with aging populations, high debt burdens and low productivity growth. Such societies face a
tough choice: structural reforms, like upgrading judicial and education systems and liberalising markets, or tinkering with central bank independence.
Structural reforms are critical for long-term potential growth; however, they tend to increase competition in the short term, which does not help inflation
return toward target. Even if governments embrace reforms, central banks’ inflation mandates oblige them to take action in some way. In those societies
unwilling to embrace reforms and incapable of generating growth endogenously, central bank independence might come under threat.
Monetisation is not something investors should wish for. We are unaware of any country that did “just a little bit” of monetisation without creating “a
lot” of inflation; it’s hard to put the inflation genie back in the monetisation bottle. From 1795 in France to 2007 in Zimbabwe, financial history has
witnessed 56 episodes where budget deficits financed by the monetary
authority produced hyperinflation. The turning point from price stability to hyperinflation was often short and nonlinear (see Figure 4), suggesting once
started, it’s very hard to stop. For example, Germany’s consumer price inflation averaged 1.9% from 1900 to 1914 before jumping to 169% on average between
1915 and 1922.
What about Europe today? Article 123 of the Treaty on the Functioning of the European Union prohibits monetisation, and
despite critics in Germany, Draghi pointed out on 10 March that “We [the ECB] haven’t really thought or talked about helicopter money.” Investors, in
Europe at least, should not fear resurgent inflation.
Eurozone growth and inflation will likely remain low. We see few signs governments are willing to address growth’s secular headwinds with structural
reforms. The marginal efficacy of monetary policy is declining. The ECB is probably done with cutting interest rates, but expect it to expand LSAP beyond
corporate bonds and into stocks, if needed. Bond yields will likely remain low too. Ten-year German Bunds currently yielding about 25 basis points may no
longer offer a moderate-yielding diversifying hedge for risky assets, like stocks. Investors seeking high-quality government bonds for diversification
purposes may have to look to currency-hedged alternatives, such as U.S. Treasuries, to play this role.
To achieve their return targets, investors may have to make structurally larger allocations to higher-yielding corporate and emerging market bonds. But
there is no free lunch. So long as growth remains low and inflation fails to respond to unconventional monetary policy, bail-ins and haircuts will likely
play a larger role in reducing unsustainable debt burdens in the future. Europe’s Bank Recovery and Resolution Directive merely formalises this process.
Active credit selection will therefore become more important than ever. The ECB’s credit easing helps to soothe debt burdens, but without governments also
helping the ECB to boost growth, it will be an ugly deleveraging.