The Silver Bullet | Europe’s Long Way out of QE Infinity

The monetary tide has turned.

The Fed is now on a clearly-flagged normalisation path, with at least two more hikes to go this year. But if normalisation was difficult to start for Janet Yellen, Mario Draghi faces three policy dilemmas which make a tightrope walk look easy.

The Eurozone has consistently beaten growth expectations over the past quarters. Yet under the hood there’s a two-speed recovery in growth and inflation amongst member countries. Core countries are leading together with Ireland and Spain, who have been early on reforms, while France, Italy and Portugal remain behind. Armed with mostly one-size-fits-all tools, the ECB will need extra skill to withdraw stimulus and keep the Eurozone together at the same time.

The first dilemma is about timing. Normalising policy early can curb inflation where it is already strong, like in Germany or the Netherlands, but could also choke any recovery elsewhere.

The second dilemma is the trade-off between higher long-term yields vs keeping government borrowing costs in check. Current 10-year core yields, below 1%, do not compensate for inflation, expected to be around 1.5% over the same horizon. Tapering bond purchases further down from the current €60bn a month can help savers to meet their pension goals and revive banks’ profitability, but it can also make it more expensive for governments to borrow, penalising public spending and investment.

The third dilemma is about short-term rates, currently still negative at -0.4%. While negative rates have kept the euro low and helped to boost exports, they also hinder bank profitability and lending activity even more than low long-term yields. The ECB has been trying to compensate for this collateral damage by paying banks to borrow under its TLTRO loans – the last of which was issued in March – but with scarce results.

Today, the consensus is for the ECB to follow the same normalisation path as the Fed: tapering bond purchases later this or next year and bringing interest rates back to zero only after that. This sequence worked well in the US. As we recently argued on the FT, we believe Europe needs a different one instead: bringing rates back to zero before the end of tapering.

The ECB weighs its bond purchases following the share of capital contributions of its Eurozone members, the so-called capital key. This means it buys more bonds from larger economies like Germany and France, not the ones with the most debt outstanding. The result is that core debt has become so scarce that investors are hoarding it, pushing its yields even lower than the central bank’s overnight deposit rate. Investors pay -0.75% to lock cash in German 2-year notes, but it is hard for short sellers to make a profit, as the cost of borrowing the debt and the difficulty of finding any to close a short position outweigh its negative yield.

Tapering QE would normalise long-end yields to more reasonable levels, but it wouldn’t solve the scarcity problem. It could also exacerbate the gap in core-periphery spreads, potentially leaving Italy or Portugal above sustainable funding levels: we estimate that Italy would need a steady 2% nominal growth rate to make up for 3.5% funding costs over the next decade. This means that a 2% 10-year Italy-Germany spread would be barely sustainable. A better alternative would be to taper while at the same time buying more periphery debt as well as making more collateral available in the repo market to reduce hoarding of core debt.

As for short-term rates, the longer the ECB leaves them in negative territory, the more it depresses bank lending. Bank loans account for nearly 90% of corporate funding in Europe and small businesses, which generate 80% of jobs, rely mostly on banks. This means the central bank should look at credit, not monetary aggregates to judge a successful transmission of its stimulus. Corporate loans have stabilised, but they aren’t growing. While banks often blame this on a lack of demand, it is still more profitable for them to buy government paper, rather than lending to risky businesses at near-zero rates against their cost of capital. We suspect that a large part of today’s €233.5bn TLTRO borrowing will in fact end up in government debt.

For these reasons, we think the ECB should normalise interest rates before ending bond purchases. This is the best policy option for financial stability. It is also the most challenging. To do it, the central bank would have to justify a delay or an adjustment in tapering, acknowledging that some countries need more support than others. This may sound unpopular in Germany, where elections are approaching, but it is the right long-term decision.

In his latest press conference, Mr Draghi repeated the standard statement saying that policy rates are likely to remain low beyond the end of QE. But some in the ECB governing council are pointing in a different direction: Mr Nowotny recently said the central bank doesn’t have to follow the same normalisation sequence as the Fed, while Mr Visco said the time between the end of QE and rate hikes can be shortened.

To hang together, Eurozone leaders need to make a number of difficult decisions. These include giving leeway to Greece over its debt, establishing a common budget for infrastructure and defence, and recognising that monetary policy needs to adapt to the different rates of growth of its members. Like in the past, the ECB will need to lead the way.

The ECB’s Three Dilemmas

Dilemma #1: A two-speed recovery. The Eurozone has a two-speed recovery underway, as the gap widens between countries experiencing high growth and inflation, and those still lagging behind. The roots of this divergence lie in how individual countries dealt with the fallout of the Eurozone crisis: countries which restructured their banking systems and implemented necessary policy changes, like Spain and Ireland, are now experiencing a stronger recovery than other Eurozone nations. A two-speed recovery makes the ECB’s normalisation path challenging. The central bank needs to weigh the benefits of providing further monetary support to countries that need it against the risk of over-heating growth in countries that have rebounded.

Dilemma #2: Normalising long-term yields vs keeping government funding costs low. Savers and pensioners have been among the major victims of negative rates and QE, which suppressed both asset returns and discount rates applied to pension liabilities, leading to larger funding gaps for pension funds (see IMF Oct 2016 GFSR). As estimated by MSCI, the majority of European countries saw an increase in pension underfunding ratios from 2015 to 2016 (see left). Therefore, an exit from QE and gradual yield normalisation should help European pension funds plug their funding gaps and support savers in general. However, tapering bond purchases may also lead to an uneven rise in long-term yields across countries, making it more expensive for governments in the periphery to borrow. This could potentially raise debt sustainability concerns, especially in countries where nominal growth is still weak, like Italy. According to our estimates, Italy could see a gradual rise in its public

Dilemma #3: Negative rates hinder bank profitability and lending volumes. In our view, negative short term rates have a more adverse impact on bank profitability than low long-term yields. According to ECB research, the level of short-term rates is more important thant the slope of the yield curve for the net interest margins of banks with a higher proportion of floating rate loans, which is the case in a majority of Eurozone countries. Bank equity valuations, which largely influence banks’ ability to lend, are also more closely corrrelated with short-term rates. One remedy the ECB has been providing is its TLTRO loans, with the final round of auction in March. However, take-up so far has been underwhelming (utilisation of TLTRO II has been €740bn, out of which €401bn was rolled from TLTRO I, vs a total TLTRO II allowance of €1.6tn). As shown below, bank lending to corporates has stabilised since 2015, thanks to better capitalisation and a peak in non-performing loans. However, banks are still not incentivised to grow lending due to a lack of profitability given low interest margins and higher capital charges on business loans vs holding sovereign bonds.

Conclusions

1. The ECB’s official stance is to keep rates low beyond the end of QE, but dissenting voices are growing within the governing council. President Draghi repeated in the March press conference that rates are likely to remain at present or lower levels for an extended period and well past the horizon of QE. However, Mr Nowotny recently suggested that the ECB might not follow the “tapering first, hike later” sequence as in the US, while Mr Visco said that the period between the end of QE and rate hikes can be shortened.
2. Tapering before hiking rates has worked in the US, but may not be the best exit path for Europe. Compared to the Fed, the ECB’s policy normalisation path is going to be trickier: it has to balance among a two-speed recovery, a potential widening in core-periphery sovereign spreads when QE is removed and a more bank-centric financial system.
3. The optimal, though politically challenging, solution: hike rates before tapering. Hiking rates before tapering serves the dual-benefit of boosting bank lending and supporting savers and pensioners, while still keeping peripheral government funding costs low. However, this solution is politically challenging. To implement it, the ECB would need to justify a delay in tapering and acknowledge that Eurozone countries are running at different speeds. This approach may seem impractical ahead of German elections, but in order for the Eurozone to hang together, leaders will need to make unpopular and difficult decisions.
4. We believe investors are underestimating the upside risks to growth and inflation in Europe while overestimating the political tail-risks. We also believe that a strong pro-European Franco-German alliance could form following a Macron-victory in French elections and a Merkel-Schulz coalition in German elections (The Silver Bullet | Don’t Fret about Frexit). We are positioned to gain from this upside in credit risk, rates and equity sectors which in our view will benefit the most: financials, infrastructure and defence.