Financial Review

Thursday, June 05, 2014 – The European Central Bank Has Done Something

The European Central Bank Has Done Something
by Sinclair Noe


DOW + 98 = 16,836
SPX + 12 = 1940
NAS + 44 = 4296
10 YR YLD – .02 = 2.58%
OIL – .18 = 102.46
GOLD + 9.60 = 1254.20
SILV + .24 = 19.04


The Dow and the S&P finished with record high closes.


We start in Europe. The European Central Bank has done something. No, I’m serious, they did something; not just talked about doing “whatever it takes”, they actually took some action; nothing terribly bold; probably not enough, but something. Specifically, the ECB cut its benchmark interest rate to 0.15% from 0.25%, and the deposit rate to minus 0.10% from zero. The rate cuts will take effect next week, on June 11. They are trying the  negative interest rate, which has never been tried on a large scale, in a bid to push down the value of the euro and encourage banks to invest excess cash rather than hoard it in central bank vaults.


The ECB will also begin offering four-year loans to banks at the benchmark interest rates, under conditions meant to ensure that lenders use the money to issue loans to businesses. The loans are designed so that they can’t just borrow the money from the ECB at 0.15% and toss it into government bonds.


Also, the ECB will start buying packages of loans, or asset-backed securities; another measure designed to push lending to small businesses; right now there aren’t enough loans in the private sector to make this a big deal; but the idea is that the banks can get cheap money, lend it out, and then sell off the loans to the ECB. It’s called the targeted longer-term refinancing operations, or T.L.T.R.O., as if the world needs another financial acronym. Also, the ECB will no longer offset the impact of its holdings of bonds bought to combat the euro zone crisis in 2010 and 2011 by simultaneously withdrawing comparable amounts of money from the financial system.


This is a scaled down version of Quantitative Easing, and a very scaled down version of Abenomics. So Draghi and the ECB stopped short of using the metaphorical bazooka of full scale QE large scale asset purchases of sovereign bonds, probably because they would have a tough time working out which country’s bonds to buy; instead the ECB will purchase private sector asset-backed securities.


The idea of negative interest rates has been tried before, but not on a continental scale; still the negative part, is just a minus 0.10%, so it probably won’t be a huge game changer. If it isn’t sinking in just yet, here’s the simplified concept. Normally, if you put $100 on deposit with the bank they might pay you a small interest rate, say 1% a year. At the end of one year, you would have $101. Negative interest rates are just the opposite; if you put $100 on deposit with the bank, you would have to pay them, and so at the end of the year, you would have $99.


The theory is that when it becomes more costly for European banks to keep money in the ECB, they will have incentive to do something else with it; lend it out to consumers or businesses, for example. Or if negative rates make it less attractive for global investors to park money in Europe, it could cause the euro to fall on currency markets, helping reverse a rise in its value that has made European exporters less competitive.


Will negative interest rates work? Not necessarily. If the banks don’t start lending, they will have to start paying the negative interest rate, and then they will likely pass the cost on to the customer. They might not call it a negative interest rate, but banks are notorious for charging fees to their clients. If, or when the banks start charging fees for deposits, or however they pass along the costs, people might start pulling their money out of the banks. People might buy something when they take their money out of the bank, or they might just put it under their mattress at home.


On a smaller scale, Denmark tried negative interest rates a couple of years ago, and nothing really changed one way or the other; the Danish krona depreciated a little but it did not lead to a noticeable increase in real interest rates or an increase in bank lending.


Still, the ECB had to try something. ECB President Mario Draghi has been talking for 2 years about doing something. Now the question is whether it will work. The Eurozone faces low inflation and even deflation in certain countries. Deflation is a much bigger problem than inflation, and much less responsive to most monetary policy. Japan has been trying to escape the effects of deflation for the better part of two decades. Central banks can pump liquidity into the markets but they have a harder time creating demand in an economy.


One of the bank’s aims is to weaken the euro, which allows exporters in the euro zone to sell their products more cheaply abroad. A weaker euro also tends to push up inflation by raising the prices of fuel and other imported goods. Markets got the message. The euro fell 0.37 percent against the dollar, to $1.355, its lowest level in four months. Of course, if the Euro currency depreciates significantly, you have to wonder if Europe’s major trading partners would just sit back and fail to respond.


Will it work? I’m guessing it won’t. “Are we finished?” Mr. Draghi asked rhetorically at one point in his news conference. “The answer is no. If need be, we aren’t finished here.” Earlier, Draghi said, “If required, we will act swiftly with further monetary policy easing.” Which sounds a lot like what he said 2 years ago: “whatever it takes.”


If it sounds like the ECB’s moves are fraught with uncertainty, you are correct. This whole monetary system, whether in Europe or Japan or China or the US, is just a big experiment.


Today, Securities and Exchange Commission Chair Mary Jo White gave a speech on the stock markets and High frequency trading and dark pools. Depending on perspective it was either a major crackdown or same old same old. Mainly she said the SEC will start the process of looking into these things, which is disappointing because the SEC is supposed to be the regulator of these things. Instead we find out the SEC is looking into developing rules targeting high-speed traders, less transparent trading venues and order-routing practices, a move designed to promote fairness for investors, shine more light on the markets and bolster stability. I knew the SEC was behind the curve on these issues, but this is just sad.


Still, I guess it’s important because it does mark the first time Chairwoman White has articulated her plan for revamping equity market structure rules since she took over at the SEC in the spring of 2013. White said she has numerous regulatory proposals in the works, including an “anti-disruptive trading” rule to rein in aggressive short-term trading by high-frequency traders during vulnerable market conditions, and a plan to force more proprietary trading shops to register with regulators and open their books for inspection.


Dark pools allow investors to execute trades anonymously and do not make trading data available until after the trade is complete, if at all. White says she wants more transparency for the dark pools, and the SEC is seriously thinking about finding out who and where these dark pools are and maybe asking them to disclose more to the public and to regulators about how they operate. Any regulations that are ultimately proposed will have to be vetted through a public comment process and approved by a majority of the SEC’s five commissioners. But ultimately, Chairwoman Mary Jo White wants the SEC to actually understand how the stock markets work. And to this end the SEC seems to be all in favor of disclosure. To be fair, disclosure is the SEC’s answer to most questions, but it’s especially the answer to questions that the SEC doesn’t especially want to talk about.


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