THE MARKET IS MISSING THE BIG PICTURE

2016-05-12 6pm EDT  |  #Draghi #ECB #Fed #QE #stocks #bonds #negative rates

It’s a shame Europe and Japan ventured down the negative rates road. Although Draghi’s first slip to negative rates was not met with selling, the subsequent move to negative 40 basis points and the Japanese experimentation with below zero rates was uniformly slammed by the market. Investors have concluded negative rates cause financial stress and do more harm than good.

As reported by the FT, Larry Fink believes negative rates are counter productive:

This reality has profound implications for economic growth: consumers saving for retirement need to reduce spending…A monetary policy intended to spark growth, then, in fact, risks reducing consumer spending.

And during a Bloomberg interview, former bond king Bill Gross said “negative rates are not the way to go. They are proving to be a disaster, and certainly not an elixir for economies on a global basis.”

This realization has drawn all the attention away from the ECB and BoJ’s quantitative easing programs, and instead squared the discussion firmly around the Central Banks’ supposed inability to ease any further. Those who believe the Central Banks are now powerless argue negative rates were the next evolution in easing, and the fact it was counter productive proves the end game is upon us. This is such a load of crap. Although I agree negative rates are far less effective than hoped, and could well be hurting more than helping, this does not mean previous programs have lost their effectiveness. Central Banks experimented with negative rates, had a bad trip, and will hopefully give up pursuing this method of easing.

All this failed experiment ensures is that future easing programs will center even more on quantitative easing. It does not mean that quantitative easing has lost its effectiveness. Central Banks are by no means powerless. They simply meandered down a foolish path. Don’t mistake the short term negative market reaction to negative rates as the end of the road for Central Bank aggressive easing.


European QE

The market is missing the big picture. Too many investors are focused on negative rates instead of the monster ECB QE program that is staring them in the face.

All the attention is focused on Draghi’s further reduction of interest rates, instead of the fact that he increased the monthly QE buying from 60 to 80 billion. He also expanded the list of eligible assets to include corporates. And the coup de grce is the new TLTRO program.

In September 2012 when Bernanke introduced the infamous third QE program, dubbed QE infinity because of its open ended nature, the Federal Reserve was initially buying $40 billion a month. A few months later, he increased it to $85 billion a month.

During the next year or so, the Fed increased their balance sheet by $1.8 trillion, and in the process, goosed the S&P 500 up 46%.

The ECB’s current program is 80 a month, before TLTRO. That’s over $90 billion US dollars. The GDP of the EU is roughly the same size as the US, so the current ECB QE program is on par with Bernanke’s most effective QE program.

But that’s not including the TLTRO program which has been labelled TLTRO II. The previous TLTRO (targeted long term refinancing operations) was a little bit of a disappointment. It didn’t get the uptake the ECB hoped.

The ECB has countered this by making this second TLTRO even more attractive. The Economist had a great article highlighting the differences with the new program:

Amid the volley of tricks Mario Draghi, the president of the European Central Bank (ECB), deployed earlier this month to revive the sluggish euro-zone economy, “targeted longer-term refinancing operations”, or TLTROs, received little attention. For one thing, the ECB has been trying TLTROs (extending cheap credit to banks that boost lending to businesses) since 2014. Moreover, next to ever-more-negative interest rates and ever-bigger bond purchases, TLTROs seemed mundane. But if you look at the fine print, the ECB is offering to pay banks to lend.

To encourage credit growth, the ECB has been charging banks for parking excess reserves with it (those negative interest rates). The new TLTRO II scheme is supposed to increase the incentive to lend, by returning some of the money the ECB is making in this way to banks that increase their stock of corporate loans. Those that raise their lending above a certain target will be paid as much as 0.4% to borrow from the ECB, with the precise rate depending on how liberally they splash the ECB’s money around.

The forebear of the current scheme, TLTRO I, was not quite as generous. It offered banks very cheap loans if they increased lending. It was aimed at countries like Italy and Spain, where monetary easing had not reduced borrowing costs by as much as it had in Germany or France.

Some saw TLTRO I as a damp squib. Only half of the 400 billion ($436 billion) on offer in its early stages was taken up, and later demand dropped off further (see left-hand chart). Bank lending to firms in the euro area in January was the same as it had been in September 2014, at the scheme’s launch. The banks that borrowed from the ECB under TLTRO I did expand credit, but largely in countries with already healthy lending, such as Germany and France.

Mr Draghi is taking few chances with the new, beefed up, TLTRO II. Whereas TLTRO I loans have to be repaid by September 2018, irrespective of when they were made, TLTRO II loans will last four years from the date of issuance. TLTRO I loans can also be called in if the borrower fails to meet its lending target; TLTRO II loans will not be recalled, and the interest on them will not rise above 0%, even if lending targets are not met. And banks will be eligible to borrow far more: TLTRO I limits the loans on offer to 7% of a bank’s outstanding corporate credit; under TLTRO II the cap will be raised to 30%.

Marco Stringa of Deutsche Bank notes that TLTRO II even offers banks protection against speculative attack, as they will be able to use the cash to buy back their own bonds if necessary. Credit Suisse summarised the scheme’s conditions as “extremely favourable”, and added: “We expect markets to notice, eventually.”

Stop and think about this for a second. The ECB already has in place a QE program slightly larger than the biggest US program, and on top of that, they are lending money to banks on locked in basis for 4 years at a negative rate! The banks are literally being paid to expand credit!

The US had a similar program in the depths of the 2008 credit crisis, albeit it was not at a negative rate. The problem was that there was a stigma associated with taking the money, so it was not immediately popular. But we now know that our favourite Vampire Squid had no moral qualms taking the money, and used the program to its fullest. From Bloomberg:

Goldman Sachs & Co., a unit of the most profitable bank in Wall Street history, took $15 billion from the U.S. Federal Reserve on Dec. 9, 2008, the biggest single loan from a lending program whose details have been secret until today.

The program, which peaked at $80 billion in loans outstanding, was known as the Fed’s single-tranche open-market operations, or ST OMO. It made 28-day loans to units of 19 banks between March 7, 2008, and Dec. 30, 2008. Bloomberg reported on ST OMO in May, after the Fed released incomplete records on the program. In response to a subsequent Freedom of Information Act request for details, the central bank disclosed borrower names, amounts borrowed and interest rates.

ST OMO is the last known Fed crisis lending program to have its details made public. The central bank resisted previous FOIA requests on emergency lending for more than two years, disclosing details in March of its oldest loan facility, the discount window, only after the U.S. Supreme Court ruled it had to. When Congress mandated the December 2010 release of data on special initiatives the Fed created in its unprecedented $3.5 trillion response to the 2007-2009 collapse in credit markets, ST OMO – an expansion of a longstanding program – wasn’t included.

“The Fed has come a long way over a long period of time as far as transparency,” said Raymond W. Stone, managing director and economist with Stone & McCarthy Research Associates in Princeton, New Jersey. “They thought counterparties might be harmed, but now so much time has passed that the information is not as sensitive anymore.”

Although I am as critical of Goldman’s hypocrispy as the next guy (they are definitely not doing God’s work), I harbor no ill will for their use of this program. The Fed wanted banks to take the money. The fact everyone else was too chicken shit to strap it on like Goldman was their own fault.

Goldman made out like bandits from these programs. And the same thing will happen with this new TLTRO. The ECB is writing banks a cheque. They just need to step up and take it.

This program is definitely under the radar of most market participants. When I googled it, I had trouble even figuring out the total size of the program. Eventually I tracked down a piece by Fulcrum Asset management that spelled it out:

In terms of size, banks will be able to borrow up to 30% of eligible loans net of their borrowing in the 2014 TLTRO (currently EUR 212bn). Eligible loans comprise loans to nonfinancial corporations and households (excluding mortgages) in the Euro area. According to ECB data, this equals EUR 5.6tn as of January 2016, making the potential size of the new TLTRO programme as large as EUR 1.4tn.

The TLTRO is offered out on a quarterly basis, but the important thing to realize is that it has not even started yet! That’s right, the first auction is scheduled for June.

The wave of liquidity the ECB has unleased on the market is immense.

This tsunami is not getting nearly enough attention. Everyone is busy fretting about negative rates, meanwhile the ECB is writing the biggest blue tickets in the history of Central Banking.


Corporate issuance

In the mean time, issuers are lining up to take advantage of this terrific opportunity. Day after day, corporations are issuing record amounts of bonds. This is exactly what the ECB wants to happen. On top of that, even riskier sovereign are finding bids for long dated paper. Recently Spain sold some 50 year paper at a 3.5% yield. For money supply to grow, someone has to borrow.

The ECB is stuffing liquidity into the system. The market thinks no one will take it. In 2008 there were similar fears. Eventually the Fed offered loans at terms that shrewd players, like Goldman took the bait and cashed in. The same will happen this time. It doesn’t happen overnight, but eventually it works its way into the system.

Don’t underestimate the ECB’s program. It’s not even fully implemented yet. Everyone else seems to think it makes sense to fight the Central Banks, I am not so confident. I still think the next big crisis is the Central Bankers get their much desired inflation, but it comes way too fast.

Thanks for reading,
Kevin Muir
the MacroTourist