ECB, Corporate Bonds, and Credibility

The euro's rallied shortly after the ECB announced numerous monetary measures that in their totality were more than expected.  Many saw this as proof that monetary policy had lost its effectiveness, and central banks have lost credibility.   

Recall summer of 2012.  The market anticipated another round of asset purchases by the Federal Reserve.  The euro rallied from about $1.2050 in late July to $1.30 on September 13 when Bernanke announced the open-ended QE3.  The euro peaked two days later near $1.3175.  By earlier October it was back to $1.28 and by mid-November had fallen to $1.2660.   

There are plenty of other examples are the market's anticipatory function that has generated a "buy the rumor sell the fact" type of response to monetary policy.  It is not correct to argue that this means monetary policy is ineffective. 

One of the innovations the ECB announced earlier this month was that it would buy investment grade bonds of non-financial corporations.  The precise details are still not available, but the market's reaction suggests institutions and investors respect this decision.  Look at what has happened to corporate bonds since the announcement.  

First, in the week following the ECB meeting, European corporates brought four bln euros of new supply to the market.  This was a third of the amount that had been issued year-to-date.  Despite the supply, the premiums corporates pay over the sovereigns narrowed.   

Second, there was a multiplier effect.  Bonds that the ECB would not buy, like those below investment grade, also rallied and saw new supply.  The ECB is not going to buy bank bonds, but bank bonds rallied. Investor demand was such that the contingent convertible bond market (cocos) re-opened with new supply.  One bank reportedly received $8 bln of orders for a $1.5 bln offering. 

Will this boost inflation?  Fat chance.  Does it mean that it is a failure?  Hardly. 

One of the reasons lending by European banks remains weak is that many remain hobbled by non-performing loans.  The decline in corporate borrowing costs lessens the burden.  Banks and corporates of varying credit quality have access to cheaper capital.   Yields had been rising, but the ECB's promise of action arrested this tightening and for the first time in a year, the average investment grade debt yielded less than 1%. 

This is not to suggest that corporate bond buying is a breakthrough.  It is not.  It may not improve bank lending markedly, though could deepen the corporate bond market as new supply is generated.   The cheaper credit could be used, as it is by many US corporations, not to boost lending, but to fund share buybacks and higher dividends. Others may simply take advantage of the opportunity to bring forward financing that was already planned.    

Business investment remains relatively poor in the US as well as in Europe.  It is not the lack of funds or too expensive of funds, but insufficient opportunities.  Many industries are not employing their existing capacity.  There is not a strong desire to build more capacity.

One can fully agree that the buying of corporate bonds, which only the BOJ of the major central banks have included under its asset purchase program, is not ideal and is no panacea, without dismissing the effort as ineffective or incredible as in lacking credibility.    It is not clear how much corporate bonds the ECB will purchase.  Given the size of the market, the average daily turnover, and other considerations, ECB purchases have been projected to be around 5-10 bln euros a month.  

Assume the corporate bond purchases begin in June, and there is no further extension in the program beyond March 2017, the ECB would likely buy 45-90 bln euros in corporate bonds.  This seems like a rather modest amount given the low interest rate savings that have already been achieved.  

Of course, monetary policy cannot address all of Europe's economic challenges.  No one ever said otherwise.  If it were the only thing the ECB did, many would be right to dismiss it.  However, it is part and parcel of a larger program with different pieces aimed at different challenges.  

Ultimately, what the ECB is buying with its printing press is time, and it makes no bones about it.  It is buying time for the banks to repair their balance sheets.  It is buying time for governments to enact structural reforms.  It is buying time for the deflationary forces to subside.  It can lead the proverbial horse to the water, but if they don't drink is it really the central bank's fault? 

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