As was widely expected by the market, Mario Draghi came up with a 10 bp rate cut and brought out a bond-buying bazooka, citing a “shortfall in inflation” and “muted inflationary pressures”.
We have already discussed the ECB’s inflation estimates and the unintended consequences of ultra-accommodating monetary policy a few month ago (https://www.zerohedge.com/news/2019-07-03/how-monetary-policy-leads-destruction-middle-class-and-rise-populism).
One can well argue that the way the ECB’s inflation target will never be met. We might even end up in a situation when consumption might be suppressed because of the negative yield on assets. Economics is called a dismal science for a reason: it is challenging to come up with a comprehensible model and to make robust estimates of all the parameters in the system. However, contrary to all expectations, I think it may be feasible to end up in a positive feedback loop scenario where:
· narrowly defined inflation would go down because of the negative rates on fixed income assets
· further rate cuts
· new rounds of quantitative easing.
· a further asset price appreciation leading to a bubble
All the while keeping narrowly defined inflation (the one ECB is monitoring) very low.
Albert Einstein came up with a good definition of insanity: Doing the same thing over and over again and expecting different results.
One can be reasonably certain that the end result of rates cut and quantitative easing won’t be any different this time as well. We’ll still be left with “no inflation”, but even higher systematic leverage and inflated asset prices.
With $16,000,000,000,000 of bonds trading at negative yields, which is roughly 20% of the global tradable bond universe, pension fund and insurance company deficits are putting pressure on pension funds to match assets and liabilities. At the same time, an aging population means that pension funds’ allocations are likely to shift towards fixed income instruments as the ability to withstand larger drawdowns on capital diminishes as people age. The ECB’s official inflation projections for the Eurozone CPI were downgraded to 1.2%, 1% and 1.5% in 2019, 2020 and 2021 respectively. This means that a purchase of a five year German government bond at issuance would lead to a guaranteed loss in the investor’s purchasing power of greater than 10% upon maturity, if indeed the bond is held in a buy and hold portfolio. Further extension in duration doesn’t really alleviate the problem since 30 year German bonds trade at negative yields- even on the primary market.
Such destruction of returns on investment will obviously land a heavy blow to the pension fund system and wreak havoc on the solvency of insurance companies.
Mario Draghi seemed blatantly unconcerned at Thursday’s press conference when he was asked about the potential side effects of negative interest rates policy. However, in the Netherlands, where an official inflation runs at 2.8%, lawmakers are very much concerned about side effects of unconventional monetary policy.
The Dutch civil servants’ pension fund, ABP, with 451 billion euros of assets under management, will be forced to cut pensions next year on current forecasts.
The States General of the Netherlands is keenly aware of the consequences of such unorthodox policy which run contrary to the kingdom’s national interest. Dutch lawmakers sent a formal letter on Wednesday to the European Central Bank expressing the parliament’s concerns. Pieter Omtzigt, author of the motion, said that tiering would effectively unduly benefit the southern Europeans, traditional bank savers, at the expense of Dutch retirees. “The negative interest rates of the ECB disproportionately hit the Dutch pension funds,” he told Reuters.
We have previously discussed the rise in populism, the destruction of the middle-class, and the divide between rich and poor as a result of negative interest rates and quantitative easing. Now there’s a new dimension in the discussion: a conflict among European Member States on the distributive effects of any policy steps. It will neither help cement the fundament of the European Union nor create an atmosphere of trust in the European nation-state family.
There is a glimpse of hope though.
There was an unprecedented revolt which took place during a fractious meeting according to Bloomberg despite the upbeat demeanor of Mr. Draghi. Bank of France Governor, Francois Villeroy de Galhau, joined more traditional hawks such as De Nederlandsche Bank president, Klaas Knot, and Bundesbank President, Jens Weidmann, in resisting an immediate resumption of bond purchases. Those three governors alone represent roughly half of the euro region as measured by economic output and population. Other dissenters included, but weren’t limited to, their colleagues from Austria and Estonia, as well as members on the ECB’s Executive Board including Sabine Lautenschlaeger and the markets chief, Benoit Coeure.
There is a chance that Christine Lagarde will be able to normalize the policy and deflate the asset bubble without too many side effects. Otherwise, I am afraid we will see many more of those infamous “25-standard deviation events, several days in a row.” Earlier this week we saw how sensitive risk premia factors are to the steepness of the interest rate curve after a decade of quantitative easing and negative interest rates. After yesterday’s cut in interest rates, and a new round of quantitative easing, these premia have become even more sensitive.
We have already discussed the ECB’s inflation estimates and the unintended consequences of ultra-accommodating monetary policy a few month ago (https://www.zerohedge.com/news/2019-07-03/how-monetary-policy-leads-destruction-middle-class-and-rise-populism).
One can well argue that the way the ECB’s inflation target will never be met. We might even end up in a situation when consumption might be suppressed because of the negative yield on assets. Economics is called a dismal science for a reason: it is challenging to come up with a comprehensible model and to make robust estimates of all the parameters in the system. However, contrary to all expectations, I think it may be feasible to end up in a positive feedback loop scenario where:
· narrowly defined inflation would go down because of the negative rates on fixed income assets
· further rate cuts
· new rounds of quantitative easing.
· a further asset price appreciation leading to a bubble
All the while keeping narrowly defined inflation (the one ECB is monitoring) very low.
Albert Einstein came up with a good definition of insanity: Doing the same thing over and over again and expecting different results.
One can be reasonably certain that the end result of rates cut and quantitative easing won’t be any different this time as well. We’ll still be left with “no inflation”, but even higher systematic leverage and inflated asset prices.
With $16,000,000,000,000 of bonds trading at negative yields, which is roughly 20% of the global tradable bond universe, pension fund and insurance company deficits are putting pressure on pension funds to match assets and liabilities. At the same time, an aging population means that pension funds’ allocations are likely to shift towards fixed income instruments as the ability to withstand larger drawdowns on capital diminishes as people age. The ECB’s official inflation projections for the Eurozone CPI were downgraded to 1.2%, 1% and 1.5% in 2019, 2020 and 2021 respectively. This means that a purchase of a five year German government bond at issuance would lead to a guaranteed loss in the investor’s purchasing power of greater than 10% upon maturity, if indeed the bond is held in a buy and hold portfolio. Further extension in duration doesn’t really alleviate the problem since 30 year German bonds trade at negative yields- even on the primary market.
Such destruction of returns on investment will obviously land a heavy blow to the pension fund system and wreak havoc on the solvency of insurance companies.
Mario Draghi seemed blatantly unconcerned at Thursday’s press conference when he was asked about the potential side effects of negative interest rates policy. However, in the Netherlands, where an official inflation runs at 2.8%, lawmakers are very much concerned about side effects of unconventional monetary policy.
The Dutch civil servants’ pension fund, ABP, with 451 billion euros of assets under management, will be forced to cut pensions next year on current forecasts.
The States General of the Netherlands is keenly aware of the consequences of such unorthodox policy which run contrary to the kingdom’s national interest. Dutch lawmakers sent a formal letter on Wednesday to the European Central Bank expressing the parliament’s concerns. Pieter Omtzigt, author of the motion, said that tiering would effectively unduly benefit the southern Europeans, traditional bank savers, at the expense of Dutch retirees. “The negative interest rates of the ECB disproportionately hit the Dutch pension funds,” he told Reuters.
We have previously discussed the rise in populism, the destruction of the middle-class, and the divide between rich and poor as a result of negative interest rates and quantitative easing. Now there’s a new dimension in the discussion: a conflict among European Member States on the distributive effects of any policy steps. It will neither help cement the fundament of the European Union nor create an atmosphere of trust in the European nation-state family.
There is a glimpse of hope though.
There was an unprecedented revolt which took place during a fractious meeting according to Bloomberg despite the upbeat demeanor of Mr. Draghi. Bank of France Governor, Francois Villeroy de Galhau, joined more traditional hawks such as De Nederlandsche Bank president, Klaas Knot, and Bundesbank President, Jens Weidmann, in resisting an immediate resumption of bond purchases. Those three governors alone represent roughly half of the euro region as measured by economic output and population. Other dissenters included, but weren’t limited to, their colleagues from Austria and Estonia, as well as members on the ECB’s Executive Board including Sabine Lautenschlaeger and the markets chief, Benoit Coeure.
There is a chance that Christine Lagarde will be able to normalize the policy and deflate the asset bubble without too many side effects. Otherwise, I am afraid we will see many more of those infamous “25-standard deviation events, several days in a row.” Earlier this week we saw how sensitive risk premia factors are to the steepness of the interest rate curve after a decade of quantitative easing and negative interest rates. After yesterday’s cut in interest rates, and a new round of quantitative easing, these premia have become even more sensitive.
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