It looks as if the European Central Bank (ECB) has learned something from their progressive venture into negative interest rate policy (NIRP). All the ECB’s detractors notwithstanding, it is better to learn late than never to learn at all. The ECB does not want, after all, to kill the banks housed in the 19 countries that are members of the eurozone.
So, ECB president Draghi enlarged QE, liberalized the securities definition of stuff he would buy and lowered several policy interest rates. Some of those rates are now at zero, and one of them is now negative, -0.40%.
But he also did something else.
The Big Item
Draghi and the ECB announced that they will start a series of targeted, longer-term refinancing operations (TLTRO). The first will occur in June 2016. The term will be four years. The cost of this borrowing by a bank is likely to be a zero interest rate. But under certain conditions it will be at the negative policy rate. Thus the central bank will be paying the commercial bank to borrow from it.
Imagine what would happen in the United States if the Federal Reserve structured a program so that any bank, whether Bank of America (NYSE:BAC) or your local community bank, were to be paid by the Fed when that bank borrowed from the Fed and used the funds to make loans to you or to buy assets in the market. Right now in the US, banks take their excess funds that are not used for loans or assets and deposit them at the Fed. For an overnight deposit the Fed pays the bank an annualized rate of 0.50%. But the American bank is then charged a fee by the Federal Deposit Insurance Corporation (FDIC), so the net amount it receives from the Fed is less than the gross 50 basis points that the Fed pays. Essentially this transaction is a transfer from the Fed to the FDIC, which really means it is a transfer from the US Treasury to FDIC, since the Fed’s marginal dollar ends up being sent to the US Treasury anyway.
Let’s go back to Europe. There are 19 countries, and each of them has a national central bank. Within those countries are commercial banks. If a commercial bank raises its eligible loans by over 2.5% by January 31, 2018, that commercial bank will be paid 40 basis points on the TLTRO. If the bank fails to increases its loans, it will pay zero for the use of the funds it has borrowed from the national central bank. Note that the national central bank is a conduit for the ECB policy.
So, at the current levels in Europe, a bank can obtain TLTRO at zero and has an incentive to add to loans and assets in order to get the 40-basis-point bonus. Also note that a bank can use the TLTRO to fund certain debt instrument maturities as they come due; thus the interest margins at these banks is likely to improve.
President Draghi has launched a subsidy program to save European banks and make them more profitable. He has added that safety net to an expanded quantitative easing of about a trillion euros a year with expansion of the list of ECB purchasable items to include corporate bonds.
This is a massively expanded stimulus program. It has extremely bullish implications for financial assets and for asset prices in Europe. And because of its size and lengthy term, it is a bullish force for the entire world. We expect other NIRP jurisdictions to use their version of this model. Keep a sharp eye on Japan's next move deeper into NIRP.
We have argued that NIRP is not well understood. We have watched as it has been disparaged repeatedly. And we wish that policies in the world were conventional.
Destined To Raise Prices
But we are not in the business of hoping and wishing. We are in the business of managing assets and doing so in the stock markets of the world using ETFs and in the US bond market using individually selected bonds. It is our view that the outcome of NIRP is destined to raise stock prices to levels that will be new all-time highs.
The divergence between the US dollar PIRP and the 23-country, five-currency NIRP will add to volatility and is destined to strengthen the US dollar. Consequently, there is a downward pressure on US-dollar-denominated bond yields coming from global NIRP. And that means there is an upward pressure on stock prices and other asset prices.
We remain nearly fully invested in the US stock market in our ETF portfolios. When it comes to bonds, we believe the US-dollar-denominated sovereign credit of a high-investment-grade municipal bond, which is tax-free for an American taxpayer and yields around 4%, is one of the greatest bond bargains on the planet.
We are taking and will continue to take some defensive steps on a gradual basis. Why? Because ZIRP, and now NIRP, are spreading. They will eventually lead to a requirement for normalization. When is impossible to forecast. The reckoning may be years away. It may be sooner. We do not know.
But we do know that the eventual outcome will require defensive posturing when it arrives. Not today, but someday, and the timing is not predictable.
So today we remain fully invested and nimble. That is what we are.
David R. Kotok, Chairman and Chief Investment Officer.