Why talk of ECB tapering is sending tremors through European markets

A fresh indication of just how sensitive markets are to any shift in monetary policy settings was revealed overnight.

European Central Bank President Mario Draghi speaks to the media after he attended a session of the Bundestag Europe Commission in Berlin last month. (Sean Gallup/Getty Images)

Overnight there was yet another demonstration of the fragility of markets and their acute sensitivity to any suggestion that there could be any shift in the unconventional stances of the major central banks. A report that the European Central Bank might gradually taper its asset purchases under its quantitative easing program rippled through bond, equity and currency markets.

Bloomberg, citing unnamed eurozone central bank officials, said an “informal consensus” of policymakers had built in the past month that the ECB would “probably” gradually taper its €80 billion a month bond-buying program, possibly in steps of €10bn a month. They didn’t, however, exclude the possibility that the ECB would extend the program at its current rate beyond its current scheduled end-date of March next year.

US Treasuries fell, German bund yields rose, the euro strengthened, stocks fell and gold tumbled, with comments by a Federal Reserve bank president, Jeffrey Lacker, saying there remained a compelling case for a US rate increase when the Fed’s Open Market Committee meets next month, also contributing to market volatility.

The Bloomberg report followed comments by senior ECB officials earlier this week that recognised that the negative interest rate policy being pursued by the ECB could, in time, cause banks to reduce their lending and undermine the intent of the central bank’s policies. Previously, the ECB has downplayed the impact of negative rates on bank profits, capital generation and lending.

ECB executive board member Yves Mersch gave a speech on Monday in which he accepted that low rates put pressure on Europe’s banks and referred to analyst estimates that their returns could, in some cases, fall from 6.5 per cent to 2 per cent.

Those estimates couldn’t be ignored by the ECB he said, although he questioned whether a bank that couldn’t “weather headwinds over a few years still has a sufficiently robust business model to stay in the market.” (There wouldn’t be much of the European banking system that the ECB oversees left if the robustness of their business models were the determinant of their survival — as a system it doesn’t cover its cost of capital).

Another ECB board member, Peter Praet, conceded yesterday that the returns on equity of some of Europe’s major banks was well below their cost of capital and that cutting rates further would come with increasing risks as the costs for banks outweighed the benefits.

A resilient banking system was, he said, crucial to provide for the smooth transmission of monetary policy and to support the economy.

The ECB is, with more than $US12 trillion of global sovereign debt trading at negative yields, running out of eligible securities to buy, which by itself challenges its ability to sustain bond-buying at its current rate.

The apparent emerging shift in ECB thinking is consistent with a view among some central banks that the benefits of the unconventional monetary policies introduced by the US Federal Reserve, the Bank of Japan and the ECB after the financial crisis have been almost exhausted and that there is a need for governments to do more in the form of structural changes and fiscal stimulus.

There is also a strengthening of the view that many have held in recent years that the risks of unintended consequences and side-effects now outweigh any benefit they might still be producing.

As Janus Capital’s Bill Gross said in his latest investment outlook, low and negative yields erode and may destroy historical business models that foster savings and investment and economic growth and that the continuation of existing policies will lead to capital destruction rather than capital creation.

There is a particular impact of the negative and low-rate policies that Gross and the ECB officials both referred to: the impact on bank net interest margins and the solvency of insurers and pension funds.

Banks that operate in this negative rate environment have had their profitability squeezed even as the post-crisis regulatory reforms forced them to hold on to more capital and low-yielding liquidity. Insurers and pension funds have lower investment earnings and, with lower discount rates, rising liabilities.

A Goldman Sachs analysis issued this week estimated the aggregate pension deficit for Europe’s STOXX 600 companies at €400bn, which it said would add 20 per cent to the indebtedness of those companies.

While the size of that deficit was large, however, the company accounts showed no increase since 2013 and a small increase in solvency, which was odd given that decline in the bond yields used to discount the funds’ liabilities.

The discount rate had been held at about 3 per cent. If it were reduced by just one percentage point, the funds’ deficits would rise to about €700bn. Goldman said that while the companies may not have adjusted their accounts for their rising liabilities, the sharemarket had.

There was also some evidence, it said, that dividends and capital expenditures for companies with higher pension liabilities were weaker — the unintended consequences of monetary policies were generating adverse impacts on real economic activity.

The growing, albeit arguably much-belated, recognition among central bankers and economic commentators of the limits of the policies that were designed to shore up teetering banking systems and protect real economies doesn’t necessarily mean any early end to the ECB or Bank of Japan’s very unconventional policies or some acceleration of the Fed’s ultraconservative approach to “normalising” its rate structure.

It does, however, at least point to the drawing closer of those moments which, if they were to occur, would lead to a complete restructuring — reinstatement — of the risk and reward equations in financial markets.

Gross, for one, doesn’t think the “casino-like atmosphere” the central bankers have created is going to end well.