The president of the European Central Bank (ECB) Mario Draghi took the decision to turn interest rates negative with full conviction. That same Mario Draghi lowered interest rates further to negative -0.4% with even more conviction. Hubris? The answer to this question should be a resounding “yes,” if we look at how the current European negative interest policy might have some unintended consequences.
Someone who owns shares in banks like ING Group or ABN Amro is brave. Very brave. Not only because they refuse to worry about the value of the assets that these banks accumulated on their balance sheets (trust me, discount at least 20% of these bank assets), but because banks are walking on an increasingly thinner tightrope.
A bank, after all, lives off the interest rate margin between on the one hand its liability side and on the other hand its asset side.
While the ECB is buying tons of government bonds, interest rates on almost every asset are low, zero or negative: bad news for the left side of banks’ balance sheets.
Yet under normal circumstances banks would be able to maintain this margin by lowering the rates they offer on the right side of their balance sheets. The lower yields out of assets would be compensated for by paying lower yields on the liability side. This is, let it be clear, contingent on the fact that the market (in other words, you as saver as well as bond and equity investors) is still willing to finance at lower rates and doesn’t simply pull out its money and flees somewhere else.
Unfortunately, banks have great difficulties to maintain this interest rate margin between assets and liabilities.
Banks are unable to lower the interest rates against which they finance their liability side much further, because lenders (yes, you as saver or common bank account holder are also a lender to the bank) simply trade deposits for bank notes, deposits for paper money. Paper bank notes have something resembling a 0% yield, setting aside some negligible cost for storage and insurance.
My prediction is therefore that the ECB will be forced to either (a) bring monetary policy on a more realistic footing or (b) introduce the famous Gesell-rule which we discussed on other occasions in greater detail (the Gesell-rule is in essence a “negative interest rate on paper bank notes”).
This Is Not All, Folks: Unintended Consequences Are Becoming Apparent
In previous articles, we saw that one of the unforeseen or unintended consequences of ECB policy will be increasing volatility in bond markets. Because central banks take government bonds “off the market,” the number of government bonds that (potentially) change hands is diminished. Put differently, the more “expansionary” the ECB’s monetary policy, the “tighter” the supply of government bonds.
These government bonds are often used as collateral, especially in derivatives trading. Let’s take a look at how this works.
Derivate investors (futures, swaps, etc.) pledge collateral at one of Europe’s biggest clearing houses (something the Spanish accurately call a “compensation chamber”). The collateral traditionally consists of government debt. Clearing houses demand such collateral from derivate investors to be sure that, in case they need to pay up, they are able to deliver on their promises. But due to negative interest rates these derivate investors now lose money on their collateral: something out of the ordinary.
This implies that returns for these derivate investors are limited even further. The consequences? Higher costs for, for instance, credit default swaps, interest rate swaps and cross currency swaps, “insurance policies” used by banks to remove or lower counterparty risks, interest rate risks and foreign exchange risks.
Ironically, precisely costs like these are the ones that lower bank earnings even further and make the precarious situation of banks even more precarious.
Prices That Are No Prices
In July I wrote:
“A simple thought-experiment shows how central banks distort markets. If central banks would own 100% of bond markets, no price formation would occur. So every time a central bank approximates this imaginary state, it impairs price formation. The bigger its share, the worse the distortions.”
Citi strategist Matt King went even a step further and observed four phenomena that are currently visible in financial markets and demonstrate how central banks impair price formation and discovery:
- A greater share of global equity-market variance is explained by “macro factors.” In everyday language: the only thing that counts on stock markets are the decisions of the central bank. Everything that points at a more expansive monetary policy results in higher stock prices and everything that points at a more restrictive monetary policy results in lower stock prices. God bless stock market prices as a reflection of the whims and fancies of Mario Draghi instead of fundamental company value!
- Credit spreads aren’t responding to climbing leverage and defaults. In other words, whereas in earlier times financial intermediaries demanded a higher interest rates whenever borrowers loaded up on debt elsewhere and the number of bankruptcies began to increase, this is no longer the case. Suddenly and for some reason, we lend money against the same rate of interest to a good friend without a dime of debt as to a good friend with three mortgages, five credit cards, two consumption loans, and four cars bought on credit.
- Normal market relationships are breaking down. Under normal circumstances there was some sort of “trade-off” between different kinds of debt. During a crisis, investors would flee into government debt (with as result lower interest rates on government debt and higher interest rates elsewhere), while in normal times investors would move into corporate debt (with as result lower interest rates on corporate debt and higher rates on government debt). This is no longer the case: all bond prices move up together and move down together. Or all bonds go up, or all bonds go down.
- Cross-asset correlations are high, even though volatility is low. And the historically low volatility is perhaps the clearest signal that central banks are impairing price formation and price discovery in financial markets. Moreover, the correlation between all asset classes (commodities, stocks, bonds) is extremely high.
Because of Central Bank Interference, Recessions Will Become Increasingly Severe
We live in an era in which periods of artificial, credit-driven booms will have a longer lifespan and in which subsequent recessions will be increasingly severe. The cause is today’s monetary policy and institutions. The banking system directed and supported by the central banks is able to suppress long-term interest rates for a longer period than ever before and as a result able to finance and extend the boom period.
Let’s take Greece for example. Some Greeks banks financed almost 40% of their liability side with ECB central bank funding. No deposits, no bonds, no equity, but central bank funding. As a result, the European banking system is able to suppress long-term interest rates and postpone a credit crunch for even longer. If those Greek banks, after all, would not have been able to refinance themselves (which would be the case without ECB intervention), then these banks would have gone bankrupt and the euro banking system would have contracted.
This temporary relief for Greek banks meant an even larger distortion of price formation on capital markets, you know, those markets that are responsible for the financing of companies and real estate. This temporary relief comes at the cost of an even bigger crisis in the future.
In this era of central bank almightiness, the boom period between recessions will endure longer than before, but recessions will be deeper and more painful. The final bill that will be footed might turn out more expensive than anyone could have imagined.