REUTERS/Kiyoshi Ota
Following a much-awaited ECB meeting yesterday, President Mario Draghi and his colleagues appeared to more than meet market expectations for further easing.
They lowered all three key basic interest rates, and reduced the deposit rate from -0.3% to –0.4%. The increase in monthly bond purchases from the previous €60 billion to €80 billion beat expectations, and the ECB decided to include investment grade corporate bonds in its purchases.
A newly introduced Targeted Longer-term Refinancing Operation II (or TLTRO II, for short) would provide loans from the ECB to commercial banks at extremely low interest rates to offset any deposit flight that may follow the negative interest rates.
How can you better all that? The immediate market reaction was hugely positive. The euro lost more than 1.5¢ against the dollar, and European equities and US equity futures surged. Sovereign bond yields plunged all over Europe with the exception of Germany, the region’s safe haven.
By the time Mr. Draghi completed his press conference a short while later to explain the measures and answer questions from financial journalists, the scene had changed considerably. The euro strengthened to more than $1.12 at one point, and various European equity markets slumped by market close. Prompting the reversal was a statement by the ECB President that while he stood ready to avoid deflation, he was not going to offer indefinite cuts in rates further into negative. Prompting him was fear that depositors could withdraw funds to put under the legendary mattress rather than pay, say, 0.5% to the banks for holding their deposits.
Today, again, there was a reversal of tendencies on the equity and exchange rate fronts, suggesting a partial warming of markets to the Draghi measures. The 10-year US Treasury moved up to a 1.95% yield as risk aversion lost some allure.
What does all this mean and what are the implications for the United States? As I have been writing for some time, monetary policy has severe limitations at extremely low interest rates in keeping markets up, or sustaining an economic recovery. Japan showed this when the introduction of negative interest rates in January resulted in the yen appreciating rather than depreciating as the Bank of Japan had hoped.
REUTERS/Kiyoshi Ota
Now, markets are teaching the ECB a similar lesson. If the central bank went more negative on rates and decided to include corporate bonds in its purchases because it was running out of qualified sovereigns to buy, financial markets signaled that they wouldn’t work to boost equity and bond prices except for a short time. While today’s rally in equities, and the renewed weakening of the euro, could continue into next week, the benefits from the latest ECB moves are likely to be fleeting.
If tough love began in Tokyo and moved to Frankfurt this week in terms of central bank activity, can Washington, DC be far behind? Belief that the Federal Reserve is omnipotent - - something that has sustained financial markets since the depth of the 2008 – 2009 correction - - is likely to give way to the eventual realization that the emperor wears no clothes. While some Fed members fear that another rate hike could push US into deflation and lead to a market correction, a rate cut or another QE may not be the reliable bazookas they have been over the past 7 years.
When will the Fed's tide run out? The experience in Japan and Europe suggests that that moment may come sooner than many investors believe.
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