Friday, March 11, 2016

More of 'whatever it takes' and advance warning signs flashing

Mario Draghi continues to do "whatever it takes" to revive the Eurozone economies with a far more aggressive set of measures than expected. The latest being a cut in ECB's deposit rate by 10 basis points to minus 40 basis points, main refinance rate by 5 basis points to 0 percent, increase in monthly QE from 60 bn to 80 bn euros, and an expansion of range of assets purchased in QE from government debt, covered bonds, and small bundles of loans repackaged into asset-backed securities to cover corporate bonds.

Most importantly, the ECB will also henceforth provide liquidity through its targeted longer-term refinancing operations (TLTROs) at minus 0.4%, in effect paying banks to borrow money. The FT writes,
The ECB will hold four auctions — one each quarter from June 2016 to March 2017. Banks can bid for cash of the value of as much as 30 per cent of their loan book. At most, they pay nothing on the four-year loans, which they will not have to pay back until 2020 at the earliest. But if the banks lend more, then the ECB will pay them up to 0.4 per cent interest on the lenders’ loans with the central bank. Paying private banks to lend is novel, even for a generation of monetary policymakers used to rolling out shock-and-awe measures. Yet earlier designs of the TLTRO were touted as game-changers and in the end proved much less effective than ECB hoped. In a region drained of confidence, businesses and households might not want to borrow. Or banks could use the funds to invest in financial markets instead of expanding their loan books, pumping up asset prices but leaving the eurozone economy flat.
In other words, the success, if at all, of these measures, especially the new liquidity window, would critically depend on overcoming the banks reluctance to pass on the negative rates to their retail customers for fear of losing them. In its absence, these measures are unlikely to boost demand and investment and only likely to further erode bank's profitability. Further, it engenders several distortions in the bond and equity markets. The distortions will mount longer the rates stay below zero without igniting any revival in demand and investment.  

This latest decision deepens the uncertainty facing the global financial markets. There are atleast certain advance warning indicators of an impending crisis in the financial markets that may be flashing red. A recent BIS paper draws attention to the rising rates of high yield bond markets in advanced economies. The widening has been particularly sharp for US high-yield debt, reflecting the exposures to shale oil firms and fears of defaults,
Since mid-2014, the US high-yield spread more than doubled, reaching levels comparable to the peaks observed during the European debt crisis in 2011... One interpretation of recent events is that the high-yield rout is an isolated development, driven by US oil industry weakness; another is that this is a "canary in the coal mine" moment signalling broader fragilities. Recent experience, supported by academic research, suggests that sharp increases in credit spreads are a leading indicator of recessions. This is the case even when wider spreads initially reflect sector-specific strains: high-yield credit spreads started to rise in the technology sector at the beginning of 2000, just before the burst of the tech bubble, while financial sector high-yield spreads rose in 2007, before the Great Financial Crisis. Spreads of other risky securities in these episodes only started to widen when the broader economy turned down. More recently, while spreads have widened dramatically since the second quarter of 2015 in the energy sector, other credit spreads, including those on emerging market corporate debt, have crept up much more gradually. 

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