The Full Package


The Bank of England has just delivered a 50 basis point rate cut today at an emergency meeting. Perhaps more importantly, the Bank has also announced targeted lending plans for small and medium sized enterprises. As one observer said, “a surprise rate cut at 7am is enough to make a gentleman choke on his kipper.” The additional point to note is that the announcement has happened on Budget Day in the United Kingdom, when a large fiscal stimulus package is likely to be announced. The big picture point is that, the policy action has been assertive, targeted and coordinated in the UK. It is also the sort of coordination that the markets expected in the United States last week, but has yet to be fully delivered. To be fair to the Fed, they did act swiftly in cutting the policy rate.

The further implication of the announcement by the Bank of England, is that it raises expectations for the European Central Bank meeting on Thursday. Of course, the challenge for the ECB is that the deposit rate is already negative. Moreover, as we have often noted, the cure (negative rates) might be worse than the disease (below trend growth and inflation expectations).

From our perch, negative deposit rates have contributed to the downward pressure on European bank net interest margins and eviscerated profits. In turn, extremely low bank profitability has likely retarded the credit transmission mechanism. Put another way, it is not obvious that a further cut in the deposit rate will contribute to any economic stimulus. The ECB should also ask themselves why European banks trade at 40% of book value.

On the positive side, the ECB may follow the Bank of England and announce targeted lending measures for small and medium enterprises. That would be a positive development. The Bank may also announce additional TLTROs and asset purchases, while the latter has also largely been ineffective, the real target of quantitative easing and dovish forward guidance is the currency. As we noted recently, the aggressive emergency rate cut by the US Federal Reserve combined with the collapse in expected short rates has dramatically narrowed the gap between German and US yields (converging US rates toward European yields). That likely contributed to the recent rally in the euro exacerbated by positioning (chart 1).

From a macro perspective, the recovery in the euro has tightened European financial conditions when a number of member states like Italy were already experiencing a severe demand shock. While the ECB should act tomorrow, what European equities need is sustained and aggressive fiscal policy in the order of 60 billion euros from Germany. While that concerted policy action remains absent, European equities are likely to remain a value trap and we will prefer US and Asia in the recovery phase.