ECB, QE and so long to that damn negativity On the potential death of that long awaited negative deposit rate, interesting thoughts from HSBC's Steven Major below if sovereign quantitative easing does eventually raise its head in Europe. But first, a necessary nod to QE skepticism from Peter Stella: Rather amazingly, a crude quantitative measure of ECB stimulus - the sum of refinancing operations and securities held for monetary policy purposes - peaked the very month of Dr. Draghi's [whatever it takes] speech. Those who are now seeking QE apparently believe that, despite the inverse correlation between quantitative stimulus and actual results, an increase in the size of the ECB balance sheet will lead to an outcome superior to that associated with the increase in policy "size" evident above during the 14 months prior to the Draghi speech. During that time, the sum of ECB monetary operations instruments expanded by 168 percent without any discernible palliative impact on markets. So if the definition of insanity is repeatedly trying the same behavior and expecting different results, the market would appear slightly insane. Or perhaps it is simply guilty of failing to fully comprehend the complexity of monetary operations, and more specifically, which monetary medicines work and which do not. Add to that scepticism HSBC's point that the ECB's target is a bit out of date - since the ECB's balance sheet was last at EUR3trn, the Fed's QE3 increased the excess reserves in the balance sheet from USD1.5trn to USD2.7trn, an 80 per cent increase. Applying the same increase to the ECB's balance sheet over this time period would already have taken it to EUR5trn. And that's before we even mention the BoJ. Ho hom. But let's suppose, after buying loads of other stuff, all (political and practical) obstacles to purchases of the debt of eurozone countries are overcome and the ECB goes ahead with some sovereign QE, which market prices seem to imply is expected. Well, according to Major, the ECB's deposit rate would have to be increased, which would be bad for bunds: The negative deposit rate is an impediment to large scale ECB bond-buying from banks that will have little incentive to sell their bonds, knowing that in return they will effectively be taxed if the cash is deposited at the central bank... This at least is the experience gleaned from QE elsewhere... When the central bank buys bonds from banks, the resulting cash-flow has returned to the central bank through the deposit facility. Central bank accounts show an increase in the reserves (liability to the central bank) which is equal to the asset purchases. The money didn't go anywhere. If we are right and it is difficult for the ECB to buy large quantities of Sovereign bonds from banks whilst the deposit rate is -20bp (see Figure 7), Sovereign QE would likely be complemented by an increase in the deposit rate. Clearly this action would push yields on core bonds higher and we would argue that increased probability for ECB sovereign QE is likely to be negative for the Bund market. It could be that the ECB plans to buy bonds as if they offer a positive interest rate, paying an above market price to holders who expect their deposits to be taxed by the negative interest rate. It would effectively pay a premium to compensate for their own negative deposit rate. Or the ECB might go directly to the asset managers to buy bonds, thereby dis-intermediating the banking system. But in the former situation, says Major, the ECB would end upholding bonds with very low yields thereby exposing it to capital loss and negative equity in the future. A problem for another day but still a problem. While in the latter you'd have asset managers stuck with the question of what to do with cash in this environment. So you get back to the idea the ECB will have to pay interest on deposits a la every other major central bank - the BoJ pays 10bp, the Fed 25bp and BoE 50bp. (Update here as BofNYMellon's Simon Derrick emailed me the very sensible point that they might opt to keep it so as to get money flowing overseas, forcing the euro lower. Other options to achieve that goal but yeah.) But to bring it back to Stella's point above, and the more general (slightly worn) argument about QE, here's Major on the BoJ: As five-year JGB yields are currently close to 11bp, when the BoJ buys JGBs from banks the switch into central bank reserves requires only a small drop in yield. This is an illustration of how ineffective QE can become. The banking system has effectively lent the money to the central bank to make the asset purchases. Yields cannot go much lower and the money has become trapped in the system. Which suggests the ECB may be holding off in part (the other part being more anthropomorphic) because it's been in a position to assess the effects of QE elsewhere - and the necessary, but lacking, bits needed to make it work. A last bit from Major: QE elsewhere has not resulted in an increase in inflation expectations mainly because it did nothing to address the debt overhang. We would argue that until this fundamental problem is addressed it is difficult to see inflation expectations picking up. In fact the policies of the Fed and BoE were just giant asset swaps, exchanging government bonds held by the banks for central bank reserves. There may have been some positive wealth effects, most evident in equity and real estate markets, but there is little or no evidence of a sustainable increase in economic growth. Balance sheet recessions mean that consumption and investment are replaced by saving (or paying down debt). It does not matter that the interest rate is zero, there is too much of the economy that just can't take on any more debt and rather is focused on reducing previous borrowing. The ECB presumably knows this hence the reluctance, technical and legal considerations aside, to go ahead with Sovereign QE. This is why the decision to progress with Sovereign QE will presumably be because the economic backdrop is so dire. In any case, it may mean that such measures need to be taken together with steps towards more collective action at the fiscal level... More, including brief notes on Juncker and common issuance plans, in the usual place. Related links: How Juncker plans to unleash investment in Europe - FT ECB bond-buying: Last action hero - Lex Negative rates, in context - FT Alphaville Negative rates - FT Alphaville