The focus of the world this past weekend was upon the elections in Greece as once again that nation went to the polls to vote on whether to continue its commitment to the austerity measures imposed upon it by the EU or whether to reject those measures; to say that the long term fate of Greece’s place in the EU and the fate of the EU itself, hung in the balance, would not be hyperbole.
There is another potentially critical decision expected to take place this week involving the EU as the European Central Bank (ECB), the governing body of the Eurosystem of Central Banks, is debating whether to initiate another round of quantitative easing, or as it’s known in Europe, long term financing operations (LTRO). This process involves the direct purchase of assets by the ECB from European banks, with the result being an increase in the money supply and a lowering of the main refinancing rate, the EU equivalent of the Federal Funds rate, which represents the lowest and most important rate in the economy. This in turn lowers all other interest rates in the European economy, thus making it easier and cheaper to borrow money. Given the current unsustainable sovereign bond yields of countries like Italy, lowering the cost of borrowing is critical to avoid having to bailout yet another national banking system. A flow chart that is quite helpful in understanding the LTRO can be found here.
All of this seems very technical, even opaque, and perhaps more importantly very far away. After all, what do the actions of the ECB in regards to the main refinancing rate have to do with rates here in the United States? How does it impact the interest rate on a mortgage or on money invested in a CD? The impact is greater than the average American might realize. With the list of European countries whose banking systems are either unstable or perceived as unstable growing, more investors will be seeking safe haven for their money, with the destination of choice being U.S. Treasuries. This will lead to an increase in Treasury prices and a corresponding decrease in Treasury rates. Lower Treasury rates will lead to lower rates throughout the economy, making it easier and cheaper to borrow. Additionally a weaker European economy will lead to the purchase by Europeans of fewer U.S. exports, thus keeping the Federal Fund rate low and depressing what banks pay on savings accounts and CDs. The continuing economic crisis will weaken the Euro relative to the dollar, making U.S. exports less competitive, which will slow our economy and again, lead to lower interest rates. The ECB’s decision on whether to implement another round of LTRO, therefore, has the potential to impact domestic interest rates in a variety of ways.
All of this is very nice in theory. However, with long term Treasury yields already at or near historical lows, it is questionable just how much lower they can go regardless of whether there is or is not additional LTRO activity in Europe, a continuation of the economic crisis and further weakening of the Euro. Interest rates in the United States have been historically low for years and it has done little to incentivize a country focused on deleveraging, not on taking advantage of low interest rates to purchase homes. A significant decrease in mortgage rates is unlikely given that 30 year fixed mortgage rates are already at 40 year lows, as shown here. What is likely is that Europe’s economic malaise will keep U.S. rates compressed at their current levels as their struggles provide additional headwind to our economic recovery.
Additional LTRO will have a great impact on the short term stabilization of Europe’s banking system. However, the LTRO represents nothing more than a band aid on a gaping wound as legislators and bankers scramble to come up with a long term solution, avoid further contagion of national banking systems in countries like Italy, and do what they can to convince the Greek people to stick with the austerity measures in place. Even with the victory of Greece’s pro-austerity parties this past weekend much remains to be done, both in that country as their politicians struggle to build a coalition and throughout the continent as Europe’s politicians struggle to build a consensus as to what the next step is. Until Europe finds permanent, long term solutions to its economic issues U.S. rates will remain much at or near their current levels.