The European Central Bank's (ECB) latest stimulus package announced in March continues to be a lightning rod for controversy. At the center of the tempest is the issue of negative interest rates as yields from Japan to the eurozone to Denmark to Switzerland to Sweden flame out to nothing - or even less. Add to the mix last Wednesday's (8 June) ECB foray into the European corporate bond space, the Brexit referendum vote on the 23rd of June and fears about global growth - and you have investor uncertainty hitting historic levels. Those fears were on display at Friday's (10 June) market close: The yield on the 10-year Treasury note in Germany and Japan hit all-time lows as investors slapped their respective safe harbor cards to the table while claps of thunder rolled across the horizon. As German debt rallied with a surge of safe harbor plays, the resulting spread between German 10-year Bunds with Spanish and Italian debt issues of similar duration widened. With banking fragmentation across national boundaries increasing, investors appear to be questioning central banks' ability to either boost economic growth or create inflation, placing monetary policy at the crossroads of efficacy.
In the euro area, German savers are perhaps the biggest losers as interest rates across the eurozone continue to plunge. Germany is the largest economy and by most measures is the main driver of economic growth in both the European Union (EU) and the eurozone. Yet German homeownership rate, at 44% is the lowest in the EU and just under half the home ownership in Slovakia. Further, German investment vehicles of choice historically have been interest bearing accounts, either in the 1,500 local and regional banks that dot the German countryside or through insurance and annuity contracts with guaranteed fixed returns. The number of shareholders of equity positions in Germany reached 9 million or about 14% of investor positions through the end of 2015, up from 6.4% through the end of 2014. Comparable equity exposure among retail investors in the US is about 60%. This means German savers have likely benefited the least from rising asset prices due to the ECB's expansive monetary policy of the past two years.
German banks and financial institutions are likely the second biggest losers in a negative interest rate environment. The business models of those 1,500 local and regional banks depend heavily on interest spreads paid out on deposits versus those levied on borrowers. A recent study by the Bundesbank estimated a decline in the aggregate income of small and mid-sized German banks at about 25% by 2019 at current interest rates. For insurance companies, the average guaranteed fixed contract is 3.28%, according to data from the German bank regulator BaFin. Such guarantees will be difficult to meet with the 10-year Bund paying a paltry 0.023% at yesterday's market close (10 June). Financial institutions argue that negative rates have not created more demand for loans to offset the very real hits to stock prices and revenue streams. True to form, loans to non-financial institutions and households have yet to recover from their nadir in the 1st quarter of 2014. German banks have already forfeited Eur 248 million in excess reserve charges, according to Bundesbank data. Little wonder that German opposition to ECB monetary policy has been both vocal and vociferous.
In an anticipatory move in regard to negative rates on bank balance sheets, the ECB revamped its bank funding facility, the Targeted Long-Term Refinance Operation, unofficially dubbed TLTRO-II. Originally billed as a game changer in 2014, the results in real time have been much less impressive as auction participants and overall interest in the program has continued to wane. In 2015, the amount of funding disbursed by the facility came to Eur 514.336 billion for an average of Eur 42.86 billion a month. In the first four months of 2016, LTRO disbursements have slowed measurably to Eur 54.196 billion through the end of April or about Eur 13.549 billion a month.
Under TLTRO-II, the ECB will hold four auctions, one each quarter starting in June and running through March of 2017. At 30% of eligible banks' combined loan portfolios, the new facility could be worth as much as Eur 700 billion, according to Barclays' estimates. The enhanced features of the TLTRO-II program will allow banks to borrow Eur 1,000 and pay back Eur 996 if lending thresholds are met in a year's time. While the new facility puts the ECB on the hook to literally pay banks to lend, the level of such a payout will likely fall short of current negative rates in place which means participating banks will be lending into a flat yield curve where demand for loans remains weak. And in the absence of Federal Reserve movement on raising the federal funds rate, the euro remains comparatively strong, providing a significant headwind to eurozone exports in world markets.
Yet it is important not to confuse cause with effect. Low interest rates in the eurozone are a function of a variety of factors: The weakness of economic output, the lack of growth, anemic demand for goods and services, high unemployment rates, structural weaknesses both at the national and euro-level - all of which undermines the economic incentives to invest in plant, equipment - let alone the expansion of labor mixes in the private sector. Negative interest rates are an attempt at finding the real rate of interest in the greater economy - the inflection point - where the incentive to invest takes hold and becomes sustainable moving forward. Further, negative rates endeavor to shake loose that very surplus of savings from the relative safety of interest bearing accounts and investing the surplus in the broader economy. Interest rates can only increase in response to a proportionate increase in basic spending.
The introduction of corporate bonds to the ECB asset purchase program offers up a different twist to the mix. With the deep pockets of the ECB affording the possibility of crowding out most other investors in the tiny European corporate bond market, the spreads for small business loans will likely be squeezed even further. To date, there is no information as to the euro volume of corporate debt purchases. The ECB has indicated it could buy up to 70% of any corporate issue, a substantial increase from the 33% cap on sovereign debt purchases in the secondary market. For corporate issues, both the primary and secondary markets come in play. This contrasts sharply with the sovereign debt purchase program where direct ECB funding of individual member states is prohibited by treaty, forcing all sovereign debt purchases into the secondary markets. A recent announcement appears to place a cap of 33% on utility debt, by far the biggest issuer of corporate investment grade debt in the eurozone. Defining utility debt as a "public undertaking" will both decrease the pool of high quality debt and likely force the ECB to include lower levels of investment grade issues in its purchase mix.
The limiting factor of the corporate debt pool poses a critical issue for the program as a whole. The overriding issue is one of size: The European corporate bond market is about a third the size of the US. Corporate structuring on both sides of the pond is revealing. Of the 22.3 million enterprises in the EU non-financial business economy, a full 92.7% of the total has no more than 9 employees. Small and medium sized companies with 10 to 249 employees accounted for about 7% of total enterprises, while just 0.2% of total euro-zone companies employ 250 workers or more.
By contrast, US firms with 250 workers or more comprise 53.7% of total employment. About 35.7% of firms employ between 10 and 249 employees while micro-firms comprise about 10% of the workforce.
To make matters even worse, the yield on an estimated 40% of all German debt with maturities between 2 and 30 years is currently below the ECB buy threshold of -0.4%. The limitation could be critical moving forward. By design, ECB purchases of sovereign debt are based on European Commission (EC) budgetary assessments. As the largest economy, Germany assumes the greatest proportion of EC budgets and is therefore the biggest recipient of ECB stimulus funds. Financially strapped Greece and Cyprus, who both lack investment grade ranking, are precluded form the program altogether. Portugal clings by its fingertips to a BBB/stable outlook rating by the less familiar Canadian agency DBRS after downgrades to junk status by the more familiar Moody's, Standard & Poor and Fitch.
If the size and depth of the European capital market is not enough of a challenge, the age-old dilemma of diverging interest between government and corporate decision makers comes plainly into view. With such a large player as the ECB now active in a market that is a third as big as the US market, investment grade corporate issues will experience a boon of historic proportions. Expanding investment in markets with chronically low levels of demand and inflation, corporate spending on plant, equipment or expanding existing labor mixes - all prime policy objectives of the ECB - will be a tough sell despite plunging borrowing costs.
Adding to the growing discrepancy between government and corporate interests, US-based corporations with subsidiary operations in the eurozone were the biggest issuers of euro-denominated debt by nationality in 2015, comprising roughly a quarter of all debt issues last year. With demand in global markets, including the US, still weak by many measures, buying back of shares, enhanced dividend payouts and M&A activities have provided much of the growth in the S&P Index for the past several years. The S&P 500 Buyback Index has gained about 255% since March 2009, which marks both the nadir of the current bull market and coincidentally the beginning of the Federal Reserve's first asset purchase program. The S&P 500 Index is up just under 210% over the same period. Nearly a third of S&P 500 companies have cut their share count by at least 4% in the 1st quarter while more than 35% now offer a higher dividend than yield on their corporate debt, according to Standard & Poor's data. Capital goods new orders for the greater US economy fell 0.8% in April from March and fell 4.1% during the month on April 2015.
Is there a bond play here? - or is this a classic bubble in the making? - or is it some shade of grey between the two extremes? The ECB's role as a debutante in the European corporate bond market is tricky and could take on one of two very disparate paths. One play could take on the air of Handel's Entrance of the Queen of Sheba. On offer is no less than an unprecedented market divergence between debt and equities of companies with solid balance sheets and compelling business models for forward growth. There is little question of the ECB dominating this high-end investment grade niche due both to the size of the market and the growing number of issue limits that are already in the public domain. While the initial purchase estimates appear stretched at Eur 5 billion to Eur 10 billion worth of debt issues per month, the latest and likely more realistic purchase range estimates are between Eur 3 billion to Eur 5 billion per month. Yields have slipped 1% on investment grade euro-denominated debt in the eurozone, the first time since April of last year. While capital gains on corporate debt are not the usual providence of traditional bond investors, the high investment-grade niche of the European debt markets is likely poised to outperform equities through the balance of the program period that extends through March of 2017 - perhaps beyond. With the eurozone mired in the throes of deflation in three of the past four months, any upward thrust of interest rates by the ECB that would dramatically compromise appreciation on the price side is likely years in the future.
Of course, the ECB's hoped for shock and awe display could underwhelm investors and spin quickly into something more akin to a financial dirge. Within days of the ECB's March announcement, Unilever NV (NYSE:UL) (NYSE:UN) sold Eur 300 million of debt at a yield of 0.08% for five years - one of the lowest corporate issuing yields on record. Anheuser-Busch InBev (NYSE:BUD), one of the world's biggest brewers, followed suit with a record breaking issue of its own. About Eur 44 billion in euro-denominated debt issues hit the market through the end of March while another Eur 21.7 and Eur 19.7 billion in bond sales hit in April and May, respectively, according to data from Dealogic. Anticipation of the ECB entry into the corporate bond market could outstrip expectations when buying volumes over time are quantified - leaving the bond market vulnerable to a very messy pullback. Getting both the play and timing right is obviously crucial.
The actual buying of corporate bond issues is being conducted by member national central banks. Early buy trends confirm the consensus view: Utility, telecom and insurance debt appear to be early targets. Since yields and price trend in opposite directions as demand increases, yields on the international brewing behemoth InBev, the German utility RWE AG (OTCPK:RWEOY) and Spain's telecommunication giant Telefoncia (NYSE:TEF) all fell conspicuously during the course of Wednesday's trading. Bloomberg news reported on Friday that Siemens (OTCPK:SIEGY) and Volkswagen (OTCPK:VLKAY) debt were also in the mix. Curiously, non-investment grade debt could also be in the mix - a clever play by central bankers to squeeze investment into the broader economy. For its part, the ECB declined to comment on its purchases for the week, all of which will be tabulated and made public in a monthly accounting starting in July.
Hardly an aside, how the largess will be spend by corporate recipients of public funds in the eurozone will determine the utility of the program - always an outsized gamble. The goal of creating a fecund borrowing environment to stimulate investment and boost economic growth likely strays dramatically from those of corporate decision makers' trying to enhance shareholder value. Should the ECB even be in the business of directing public funds to private companies? This is a frequently stated argument of particular consequence amongst German critics of the program. Utility is likely, more times than not, a function of whose welfare is under consideration. Positive sum gain in the ideal world blurs quickly in the face of real world constraints.
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