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Weekly Economic Commentary

September 4, 2012

Dysfunction Drives the ECB

John Canally, CFA
Economist LPL Financial

Dysfunction in the European nancial markets may lead the European Central Bank (ECB) to purchase sovereign debt in the open market. The ECB may look to lower rates for consumers and businesses through another round of debt purchases. Unlike the U.S., Europe has been greatly impacted by a lack of business spending.
Please see the LPL Financial Research Weekly Calendar on page 3

The European Central Bank (ECB) holds its monthly policy meeting this Thursday, September 6, 2012, and is poised to support the European economy through the purchase of sovereign debt of Eurozone member nations. The ECB has used this approach before (in early 2010 and mid2011), but markets viewed those forays by the ECB into quantitative easing, or QE, (purchasing sovereign debt in the open market) as scattershot (at best). In recent weeks, ECB President Mario Draghi has been oating the idea of more ECB purchases, oftentimes battling the German Bundesbank (the German central bank and main predecessor of the ECB in Europe) over the ability to do so. But Draghi has been careful to say that any purchases would only come after countries have demonstrated a commitment to push ahead with budget cuts and structural reform, couched in the phrase conditionality. We will leave this quite pertinent debate over the ability of the ECB to purchase bonds and under what conditions they would do so for another commentary. This week we will explore what the ECB might be trying to achieve by purchasing sovereign debt in the open market.

To QE or Not to QE in Europe
Today, despite the two earlier rounds of quantitative easing and several rounds of measures aimed at promoting liquidity in the European banking and nancial systems, consumers and businesses still face very high borrowing rates and even difculty obtaining nancing. As a result, loans by the nancial sector to households and consumers in Europe have been shrinking for more than three years. In short, the ECB (and many nancial market participants) remain concerned that the dysfunction in the European nancial system, a symptom of the high levels of sovereign debt clogging up European banks balance sheets, may not get better anytime soon without more help from policymakers. That help may come this week in the form of another round of QE in Europe.

The ECB may authorize a QE in Europe as soon as this week.

ECB vs. Fed: Different Approaches to QE

It is interesting to note however, that what the ECB is trying to accomplish with another round of QE is slightly different from what the Federal Reserve (Fed) is looking to achieve as it prepares to do a third round of quantitative easing as soon as next week. The Fed

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Mortgage Rates Are Rising in Italy

U.S. Commitment Rate: Conventional 30-Yr Fixed Rate Mortgages, FHLMC, % Italy: New Bank Loans for Home Purchases, % 8 7 6 5 4 3 2 02 03 04 05 06 07 08 09 10 11 12

is contemplating purchases of and therefore reducing the supply of nearly riskless assets (U.S. Treasuries and high-quality mortgage backed securities) in an effort to push large pools of private investors (pension funds, hedge funds, etc.) into somewhat more risky assets like municipal bonds, corporate bonds, and high-yield bonds. If the ECB wanted to achieve this goal, they might simply purchase German bunds on the open market. Instead, the ECB is targeting the severe malfunctioning in the price formation process in the bond markets of euro area countries, as stated by the ECB after its last policy meeting in early August 2012. By purchasing bonds of peripheral European nations (Portugal, Ireland, Spain etc.) where bond markets are currently pricing in a relatively high probably that these countries will eventually leave the Eurozone the ECB hopes to help reset prices in a dysfunctional market, reassure market participants of the irreversibility of the euro, and in the process, lower the cost of borrowing for businesses and consumers in those countries.

European Consumers Are Not Seeing Lower Rates

The nearby charts help to illustrate the problem. Figure 1 is Italian mortgage rates versus mortgage rates in the United States. While not strictly an apples-to-apples comparison (mortgage loans in Europe tend to be set from ve- and seven-year government debt rates, while xed rate loans in the United States are tied to 10- and 30-year Treasury rates), it is clear that the low ofcial rates in Europe (the ECBs overnight lending rate is 0.75%), and plenty of liquidity in the banking system, are not translating into lower rates for consumers. While mortgage rates in the United States have moved sharply lower in the past ve years, from well over 7.0% to well under 3.0%, mortgage rates in Italy have moved substantially higher. Interest rates on other types of consumer loans in Europe are rising as well, dampening businesses ability to expand, and consumers ability to make purchases. Thus, a key goal of another round of debt purchases by the ECB would be to lower borrowing rates for consumers and businesses.

Source: FRB, Bdlt, Haver Analytics 09/04/12 (Shaded Areas Indicate Recession)

Uncertainty Surrounding the Sovereign Debt Crisis in the Eurozone Is Severely Impacting the Flow of Credit to European Corporations
Loans by European Banks to European Businesses, Year-Over-Year, % Change, Seasonally Adjusted, Bil Euros Loans by U.S. Banks to U.S. Businesses, Year-Over-Year, % Change, Seasonally Adjusted, Bil $

European Business Unable to Invest or Hire

Another Eurozone woe that may be ameliorated by a sustained round of sovereign debt purchases by the ECB would be the availability of credit. Figure 2 compares the year-over-year percentage change in commercial and industrial (C&I) loans by U.S. banks to the business sector in the United States to the similar metric in the Eurozone. The level of C&I loans outstanding, which is a component of the LPL Financial Research Current Conditions Index (CCI), is nearly 15% higher than a year ago. In the Eurozone, it is a completely different story. Loans by monetary nancial institutions (MFIs) in Europe mainly banks to European businesses have contracted over the past year, after rebounding modestly in the rst year of the recovery (2009 2010) from the Great Recession. Without capital from banks and other nancial institutions, European businesses cannot invest in or expand existing operations, or hire new workers. The persistent lack of

22.5 15.0 7.5 0.0 -7.5 -15.0 -22.5 02 03 04 05 06 07 08 09 10 11 12

Source: ECB, FRB, Haver Analytics 09/04/12 (Shaded Areas Indicate Recession)

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LPL Financial Research Weekly Calendar

U.S. Data
2012 3 Sep 4 Sep


Global Notables

Holiday ISM Manufacturing (Aug) Construction Spending (Jul) Vehicle Sales (Aug) Democratic National Convention begins

EU Meets on banking union Australia: Central Bank Meeting EU President van Rompuy meets German Chancellor Merkel Italys Prime Minister Monti meets French President Hollande Canada: Quebec Provincial election Brazil: Industrial Production (Aug) Germany: Bond Auction Eurozone: PMI- Services (Aug) Thailand: Central Bank Meeting Canada: Central Bank Meeting EU President Van Rompuy meets French President Hollande Brazil: Inflation (Aug) ECB Meeting BOE Meeting Spain: Bond Auction Spanish Prime Minister Rajoy meets German Chancellor Merkel France: Bond Auction Sweden: Central Bank Meeting Malaysia: Central Bank Meeting Peru: Central Bank Meeting Germany: Exports and Imports (Jul) Mexico: Central Bank Meeting APEC Summit in Russia

5 Sep

Productivity (Q2)

6 Sep

Challenger Layoff Announcements (Aug) ADP Employment (Aug) Initial Claims (9/1) ISM Non-Manufacturing (Aug)

7 Sep

Employment Report (Aug)

U.S. Banks Lending Standards for Business Loans Have Eased While Lending Standards Set by European Banks Have Tightened Recently
Business Lending Standards: European Banks, %* Business Lending Standards: U.S. Banks, %

business investment in Europe has led to persistently high unemployment, and most likely underemployment as well, slower economic growth, and, ultimately, higher budget decits, which are at the root of the overall dysfunction in the European nancial system. In addition, the absence of business spending in Europe has had a major impact on imports of capital goods into Europe, which, in turn, has dampened export growth in China, Japan, and the United States.

100 80 60 40 20 0 -20 -40 03 04 05 06 07 08 09 10 11 12 Source: FRB, ECB 09/04/12 * Diffusion Index: % of respondents reporting tighter lending conditions less % of respondents reporting easier lending conditions.
The Lending Standards Line: Ascending = Getting Tighter Above Zero = Tight Below Zero = Easy Descending = Getting Easier

European Banks Overly Cautious With Lending

Higher rates and reduced availability of credit for European businesses and consumers are only part of the story. Saddled with billions of dollars of heretofore safe sovereign European debt on their balance sheets, European banks remain overly cautious about who they lend to. Tighter lending standards on top of higher rates and reduced availability exacerbate the economic and nancial situation in Europe. By purchasing the debt of certain countries in the open market, the ECB hopes to break this logjam and make credit more readily available to the private sector. Figure 3 compares the lending standards for business loans made by U.S. banks and banks in the Eurozone. Over the past three years, as the Fed embarked on several rounds of quantitative easing and U.S. banks
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In Europe, banks lending standards for businesses remain relatively tight and have actually tightened signicantly over the past year or so, as the sovereign debt crisis in Europe has intensied.

shed bad assets built up during the housing bubble, bank lending standards for business loans eased dramatically. In Europe, however, after becoming less restrictive in the immediate aftermath of the Great Recession, banks lending standards for businesses remain relatively tight and have actually tightened signicantly over the past year or so, as the sovereign debt crisis in Europe has intensied. In recent weeks and months, the ECB has sounded especially strident about the need to address the severe malfunctioning in the price formation process in the bond markets of euro area countries as well as the nancial fragmentation that hinders the functioning of monetary policy in Europe. By taking steps toward more aggressive and systematic bond buying, the ECB hopes to begin to address the dysfunction, and help to get badly needed credit owing again to struggling European businesses and consumers.

LPL Financial Research 2012 Forecasts

GDP 2%* Federal Funds Rate 0%^ Private Payrolls +200K/mo.

Please see our 2012 Outlook for more details on LPL Financial Research forecasts.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specic advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. * Gross Domestic Product (GDP) is the monetary value of all the nished goods and services produced within a country's borders in a specic time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a dened territory. ^ Federal Funds Rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Private Sector the total nonfarm payroll accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The nonfarm payroll statistic is reported monthly, on the rst Friday of the month, and is used to assist government policy makers and economists determine the current state of the economy and predict future levels of economic activity. It doesnt include: - general government employees - private household employees - employees of nonprot organizations that provide assistance to individuals - farm employees

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Stock investing involves risk including loss of principal. International investing involves special risks, such as currency uctuation and political instability, and may not be suitable for all investors. Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by ooding nancial institutions with capital in an effort to promote increased lending and liquidity. The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing rms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys. Challenger, Gray & Christmas is the oldest executive outplacement rm in the United States. The rm conducts regular surveys and issues reports on the state of the economy, employment, job-seeking, layoffs, and executive compensation.

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