Why Europe’s Latest Rate Cut Could Cause the Next Financial Crisis

"Super" Mario Draghi smiling for a photo-op.
1

Kangaroo court is back in session this morning after the European Central Bank (ECB) announced a new round of quantitative easing (QE). Eurozone leaders are celebrating the bond-buying program, in which the ECB will spend 20 billion euros per month on acquiring assets.

Better yet, they went one step further and cut rates again, this time by 10 basis points to -0.5% (as expected by analysts), marking a record low for the continent.

It’s all part of a larger plan to stimulate the stagnant European economy, where massive welfare programs and slowed growth have crunched prosperity.

But according to the ECB, negative interest rates are the “new normal” until inflation “robustly converge[s] to a level sufficiently close to but below 2% within its projection horizon, and such convergence has been persistent.”

What a mouthful.

The ECB even changed its targeted long-term refinancing operations (TLTRO) to support an even friendlier lending environment for banks. By eliminating a previous 10 basis point spread, euros will be flowing faster and “freer” than ever before.

Especially in light of another new policy in which banks get incentives (via preferential rates) to hit lending benchmarks set by the ECB.

It’s all hands on deck in Europe, and the central bank wants darn near everyone in more debt than ever before.

And in a vacuum, the strategy makes sense. Cheap debt has fueled growth in the United States for decades.

But in Europe, corporate debt is in a very different place than it is stateside. As of August 1, a staggering 40% of investment grade corporate debt was yielding negative.

And after the ECB’s new policy announcement this morning? That number’s guaranteed to grow. The negative-yielding debt – both from corporations and governments – has become too attractive for institutions spanning the globe to pass on.

Bond prices continue to go up, up, and away, making hedge and pension fund managers happier than a pig in Schmitt – a rural farming town in Western Germany.

The danger here, however, is not that institutions continue to make money on negative yielding debt.

What’s so hazardous is that if the ECB’s plan works and a European revival finally arrives, all that negative yielding debt will soon turn positive.

And a yield increase of only 2% would gouge corporate bond holders (mostly institutions at this point) with downright ruinous 50% losses.

It’s something we talked about a few weeks ago when negative yielding European debt spiked in late August.

Now, the ECB has made sure that the corporate bond markets will become even more imbalanced. Taking a page out of the Fed’s book, Europe is about to get a historic cash injection courtesy of their central bank.

If it works, and growth is stimulated, institutions might not survive the damage of yields swinging positive. Those that do make it out will be severely wounded, including plenty of U.S.-based investment groups that were looking for “safe” gains outside of the volatile stock market.

Much like the Fed, the ECB is stuck in a “damned if you do, damned if you don’t” scenario. Both central banks are doing what they think is best, but the collateral damage in Europe might be too much for investors to stomach.

And if I’m right, the fallout of a European recovery could be downright devastating.

As counterintuitive as that may be.

LEAVE A REPLY

Please enter your comment!
Please enter your name here