They Came to Play

I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.

Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:

“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”

All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB.  This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.

There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.

If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).


But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years.[1] Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.

Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.

If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.


The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).


Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.

[1] This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.

  1. Eric
    June 5, 2014 at 9:21 pm

    Is there a (retail) way to play european breakevens?

    • June 5, 2014 at 9:29 pm

      I am not aware of one…although that mainly means that there is NOT one in the US, but I haven’t the faintest idea whether there is something traded on a European bourse…

  2. Eric
    June 6, 2014 at 7:14 am

    I wonder if being long us breakevens plus short euro would track european breakevens pretty well.

    • June 6, 2014 at 7:18 am

      I have never studied that particular question, so I am not sure if that works or not with spot Euro. If you did a 10-year Euro swap then it ought to. 🙂

      • Eric
        June 6, 2014 at 7:23 am

        Ah, good point. I didn’t really think about that. 🙂

  3. HP Bunker
    June 6, 2014 at 8:57 am

    I’m a little confused here. The general perspective of this column has in the past been that QE-style monetary interventions could accomplish inflation and perhaps asset bubbles, but little of (positive) significance to the “real” economy. Yet in this post you seem generally supportive of the ECB’s latest steps. Does Europe not risk mirroring Japan in yet another way (and also not good)? All QE seems to have accomplished for Japan is inflation, unaccompanied by rising real wages. That does not seem like a “success” worthy of emulation.

    • June 6, 2014 at 10:34 am

      QE isn’t going to do much for the real economy, but like with Japan – who didn’t REALLY do QE until last year, in any kind of size, which is why they had a lost decade – with Europe right now deflation is a real risk. Money growth at 2% is simply not enough to have any kind of robust economy, or stable prices. So in this case they’re solving an actual problem, and using the right approach: QE. This is why the first QE from the Fed was arguably the right general idea, because they were afraid of deflation (although ex-housing we were never particularly close), but subsequent QEs made no sense since deflation was not a threat and QE doesn’t do anything for growth.

      QE is a tool for fighting deflation, and bank liquidity issues. That’s all. It just happens that right now the ECB has the right war to fight!

  4. Marshall Jung
    June 6, 2014 at 9:27 am

    I’ve been running automated searches to ferret out any retail (US only so far) inflation products. So far Proshares is the only sompany to package up BEI index into an ETF type product. These are RINF and UINF(3x ultra). They are still pretty thin volume. DB has INFL which I assume is based on thier measure of US BEI (methods here?: but INFL is even thinner on volume. It’s actually kind of hard as an average retail investor to obtain a well diversified inflation portfolio. I’ve spread my inflation portfolio over TIPS, i-bonds, commodities and a some of the BEI products I talked about earlier. Hopefully this will work well enough for US based inflation. I have not yet been able to find any European products though I have the ability to trade on those exchanges via my Fidelity acct. I’m going to place a call to the private client group rep today and ask if they are aware of anything. If I get an answer I’ll repost here to share.

    P.S. – If I win the lottery I’ll just send it over to Enduring!

    • June 6, 2014 at 10:35 am

      Ha, thanks Marshall! Sometimes people do win the lottery, so I’m crossing my fingers for you.

      Back in 2005, I proposed to Rydex a breakeven fund that would have been very easy to create. They were interested but ultimately passed. It took another 5 years before INFL, RINF, and UINF came out. I’m just ahead of my time. 🙂

  5. June 6, 2014 at 2:05 pm

    If this is really a game-changer then why was EUR/USD trading HIGHER later that day? Was the market expecting even MORE of a game changer? And if the latter is true and the market was disappointed then why did stocks trade higher? Perhaps this month’s freshly minted $45 billion from the Fed is enough to overcome everything.

    • June 6, 2014 at 2:09 pm

      I think FX traded higher because people reasoned, incorrectly, “rates can’t fall any more, and it’s rates that drive the currency.” It’s the quantity of money that should drive the currency, and the question is whether the ECB is going to create enough of a supply relative to the USD. It sure looks to me like they’re going to try and one’s opinion of the value of the currency ought to have diminished…but I think most investors rely on old rules and don’t really understand the importance of what is going on.

      Similarly, the equity guys say “QE is always good for stocks,” although they’re not entirely sure why that should be so. In this case, they probably have it right, at least for a while.

      • June 6, 2014 at 2:14 pm

        >>I think FX traded higher because people reasoned, incorrectly, “rates can’t fall any more, and it’s rates that drive the currency.” It’s the quantity of money that should drive the currency…<<

        Then why did the yen tank so severely when Abe's QE was announced? (I'm not trying to give you a hard time– I'm just coming to the conclusion that none of this makes any sense!)

      • June 6, 2014 at 2:20 pm

        Yeah, but it stopped didn’t it? So the FX guy says “gee, that didn’t work.” Of course, the yen will continue to fall, and the Euro will as well…IF, that is, the central banks follow through on their threats. Recently Japan has seemed a bit cautious (no doubling of the money supply after all, it appears) and it’s not clear whether the ECB has the legal authority or the will to do what they said they would. I wouldn’t worry too much about the wiggles.

      • June 6, 2014 at 2:22 pm

        >>…it’s not clear whether the ECB has the legal authority or the will to do what they said they would.<<

        Well that perception would certainly explain the lack of a currency move. But then (if it's correct) it's not a game-changer, right? Do you think it DOES "have the authority"?

      • June 6, 2014 at 2:29 pm

        No, but I don’t think that matters. The Fed didn’t have authority for some of the things that it did in 2008, either, but you need someone to complain. But to be clear, I think the currency move is in error and I would be long Aussie vs Euro and probably USD vs Euro although it’s hard to bet against a bunch of doves.

  1. June 11, 2014 at 7:01 pm

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