Gavekal Capital: The ECB And Kicking The Dog

Thursday, June 5, 2014

The ECB And Kicking The Dog

Today the ECB moved to once again ease monetary policy, and as a part of its package, it imposed negative rates on excess reserves.

I remember, years ago, sitting at the feet of Art Laffer at his home in Rancho Santa Fe listening to him offer his simple version of why incentives matter.  He said, "If you kick a dog, you know where it will not be--within kicking range.  If you feed a dog, you know exactly where it will be--at your side."  By moving to impose negative deposit rates, the ECB is instituting a tax on banks holding excess reserves.  This is the equivalent of the ECB kicking the dog.  Where those reserves end up is subject to debate (though we have some ideas below), but it is probably fair to suspect they will move out of kicking range.

So, where then do European banks part their excess reserves to avoid being kicked?  If the last few years is any guide, some may end up in the US banking system via European banks intra-company transfers in order to earn the 25bps the Fed is paying..  Think of a European bank operating in the US having two basic divisions--one is its European operations and the other is its US operations.  Each division maintains its own balance sheet, and each division can increase or decrease its net debit or credit position relative to the other.  In the chart below, we illustrate this idea.  Presently foreign banks (think of BNP in Paris) have a $597 billion net credit position vis-a-vis their US operations.  In simpler terms, Foreign banks have deposited almost $600 billion with their US affiliates.  With total liabilities of $2.535 trillion, this means that foreign banks have a net credit position with their US operations amounting to 23.56% of their total liabilities.  This stands in stark contrast to 2008, when foreign banks had a net debit position against their US operations amounting to over 40% of total liabilities.


Now, here is where this gets interesting.  For the last five years, there has been a pretty strong correlation between the size of the net debit/credit position of foreign banks vs. their US operations and bond yields.  In a nutshell, when foreign banks increase the amount they have deposited in their US operations, US Treasury rates fall.  In the chart below, I have plotted the Net Due to Foreign Related Institutions (the technical term for these inter-bank debits/credits) alongside 10 year US Treasury bonds.


If past is prelude, this may portend another mysterious reason why US Treasury yields are falling--the ECB is kicking the dog.