QE is dead, long live QE!
Central banks stepped in to rally markets with extraordinary monetary measures over the past few years but now have to deal with the consequences of their largesse. One of the biggest concerns is whether or not private market leverage can replace the public sector leverage. If central banks do unwind, new sources of demand need to emerge, including from the “shadow” or alternative banking system.
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The Fed is usually true to its word. So it proved again on September 18 when the US central bank opted to postpone the gradual deceleration of its vast bond-buying programme. Markets reacted to the perceived treachery with predictable hysteria, despite being regularly told by Federal Reserve chairman Ben Bernanke that the great taper caper would only begin when he deemed the US economy to be back in rude health.
So a series of unanswered questions loop around again. When will the developed world’s central banks start unwinding the extraordinary monetary measures of recent years? Are Western economies robust enough to survive without a surfeit of artificial fiscal stimulus? And if not, should the bond-buyback programme introduced by Western central banks in the dark, post-Lehman days be extended indefinitely?
With the first question it’s clear that, for now at least, we have little choice. Eurozone economies, still seeking solutions to the debt crisis that has hobbled its banks for the best part of a decade, would struggle without ongoing public stimulus. Britain’s largest banks may, by and large, be in a better state than their continental counterparts, but the broader UK economy remains “addicted to large ongoing doses of stimulus”, said Tom Budd, a London-based partner at law firm Gibson Dunn.
Even in the US the outlook is uncertain. Can it survive without stimulus? Bernanke’s speech at the September Federal Open Market Committee meeting, in which he pointed to the fragile state of the economic US recovery and the clouds hanging over the nation’s housing market, would suggest the answer is a resounding “no”.
Living without the drip?
“The Fed can only take away the stimulus drip if they believe the body has been sufficiently purged of poison,” said Peter Schaffrik, head of European rates strategy at RBC Capital Markets. “Clearly, they don’t believe it is healthy enough to operate on its own, so they are leaving it in hospital for a few more months.”
Many, including Schaffrik and Gilles Moec, co-head of European economic research at Deutsche Bank, see the taper beginning to kick in from early 2014, though that could be delayed for extrinsic reasons, such as failure in Washington to agree to a new extension to the US debt ceiling in December or January.
It’s also worth noting here that tapering means very different things in Washington, London, Frankfurt. The total amount of debt “held” by the European Central Bank through its Long-Term Refinancing Operation is about €200bn, most of which, at least at a central level, is already being quietly unwound. In the US and to a lesser extent Britain, bond repurchases are being magnified by the day. Since the onset of the financial crisis, the US Treasury has issued US$3trn worth of gross debt, some of which comes due in the 2040s.
“The whole ‘tapering issue’ isn’t about unwinding but about slowing down the accumulation of reserves, which is a totally different thing,” said Schaffrik. “We are still a long way away from actually unwinding the bond repurchase programme – that is unlikely to start happening in the next three years at least.”
“You are seeing financial fragmentation across the eurozone. Europe, despite its occasional protestations to the contrary, continues to draw in on itself”
Even if central banks start scaling back stimulus, it’s unclear what could or would fill the gap. Despite having seen their balance sheets shrink by €3.3trn in the 15 months to the end of August 2013, most of Europe’s lenders remain unloved and untrusted by investors, still trading at valuations far below 2008 levels.
“The key question is how we deal with the shortcomings of the banking sector, and how we reincentivise banks to lend to the private sector,” said Moec.
There is no simple answer to this problem. Eurozone banks, many still struggling to shore up capital and locate a route back to profitability, find themselves assailed by conflicting demands.
“They are constantly asked by regulators to make themselves stronger while also lending more,” said Alberto Gallo, head of European macro credit research at RBS. “It’s a classic Catch-22 situation.”
Politics also intrudes. Nationalised European banks, under pressure to disburse capital to favoured corporates in their home markets, are not crossing borders to lend as they once did. European corporates, however robust or highly rated, are also feeling the pinch, with many forced to borrow from local lenders seeking to heal themselves by setting interest rates at exorbitant levels.
“You are seeing financial fragmentation across the eurozone,” said Gallo. A London-based bank analyst said: “Europe, despite its occasional protestations to the contrary, continues to draw in on itself.”
One of the core concerns is the legacy of quantitative easing. Yes, stimulus was necessary and welcome. Without it, the money markets would almost certainly have dried up, along with our way of life. But at what cost? Many politicians breezily hoped that stimulus cash would flow evenly across the economy, trickling into every available nook and cranny.
Safe and steady
That has not happened. Most of the surplus cash was simply recycled blindly into the safe-and-steady global bond markets. Stimulus has also helped prop up more than a few “weak and even perhaps insolvent European financial institutions”, said Gibson Dunn’s Budd. But across Europe, smaller enterprises have struggled either to maintain old credit lines, or to tap into fresh sources of funding.
So with lenders still providing so little support to SMEs, the bedrock of any healthy economy, corporates are now looking for help outside the traditional banking sector.
“Markets are versatile,” said Budd, “They abhor a vacuum, and that fact alone gives you confidence that the non-bank financial sector will step forward and fill some of the shortfall.”
Many have little choice, at least within the embattled eurozone. In the 15 months to end-August 2013, according to ECB data, eurozone banks cut lending to corporates by €275bn, or the equivalent of all outstanding regional high-yield debt.
“In order to replace all of the loans run off by banks, you need non-bank lending to kick in,” said RBS’s Gallo. “We need to tap into other sources of finance until the banks have properly fixed themselves, and are able to start lending again.”
Many potential sources of non-bank or “shadow” finance have been identified. The European Investment Bank is looking to provide up to €20bn in funding to SMEs and mid-cap corporates: a senior EIB official told IFR that that programme is “still very much on track”.
Collateralised loan obligations are back in favour again, having fallen off the map after the financial crisis: CLO issuance in the current year to end-September totalled US$55bn, according to financial information provider S&P Capital IQ, the highest level since 2007. The high-yield debt market is also growing in popularity again, notably in troubled semi-periphery markets such as Italy. (See “Emerging from hibernation, p22)
Other experts want to see more corporates breaking into the lending business, along with asset managers, pension funds, insurance firms and even sovereign wealth funds. The UK market for peer-to-peer lending, while small, is both innovative and vigorous. More than a few leading private equity firms, awash with cash but lacking investment opportunities, are keen to start lending either themselves, or through traditional bank providers. Morven Jones, head of corporate and public sector DCM at Nomura, sees more SMEs sourcing wholesale capital from hedge funds. Nothing, it seems, is off the table.
Many corporates across the eurozone are naturally looking to the debt markets for help, though often more in hope than expectation.
“We really need Europe’s bond markets to grow in size and scale,” said RBS’s Gallo. “If we got the market for bonds and plain-vanilla securitisations really moving, it would really help the process of creating new sources of funding across the continent.”
European corporates can only look on with envy as their counterparts in the US tap into a deep well of debt market capital. “In the US, this is a non-issue,” said Deutsche Bank’s Moec. “Funding is normal. Corporates don’t need more borrowing – they are in a very strong position. Only in Europe do corporates have an issue with funding.”