Negative Rates With a Small Positive Twist

Has Super Mario lost his mojo? Markets and pundits alike are questioning the ECB's latest attempt at monetary stimulus, and there is head-scratching all around. Eurozone stocks soared on the announcement, then sank. The euro fell at first, then zoomed. Most wonder whether ECB Chief Mario Draghi has fired his last bazooka round and is now out of ammo. Our question is different: Has he finally realized negative interest rates are a headwind, not stimulus?

Here's why I ask: In addition to boosting quantitative easing (QE) by €20 billion per month and cutting all three interest rates-including the rate on excess reserves, which dropped to -0.4%-the ECB also launched another round of targeted long-term refinancing operations (TLTRO), whereby banks can borrow at the prevailing rate on excess reserves for four years, so they can in turn lend to eurozone businesses. Or, in other words: The ECB will pay banks 0.4% to lend.

This is strangely positive. Negative rates, on their own, are a drag. In theory, they're supposed to encourage lending. As the logic goes, if banks must pay to hold excess funds at the central bank (instead of receiving a small interest payment), they won't hold them. They'll instead lend a bunch more, turning those excess reserves into required reserves, stored for free. Yippee! But theory and reality rarely intersect, and they surely don't here. Banks didn't hold mountains of reserves at the ECB because of the small interest payment they used to receive. They had other reasons, like small potential loan profits (due to flattening yield curves), regulatory uncertainty and the need to rebuild balance sheets after the eurozone crisis. Loan demand wasn't exactly booming either. So when the ECB took rates negative in June 2014, banks either just ate the fee or moved idle funds from the central bank to other stable assets like high-quality sovereign debt. Higher demand for long-term bonds pulled long-term yields down across the eurozone and weighed on yields throughout the developed world, flattening yield curves a bit. Eurozone lending eventually turned slightly positive anyway, but it was despite negative rates and the advent of QE, not because of them.

Negative interest rates are a tax on banks, pure and simple. They do have a silver lining, as they lower the short end of the yield curve, steepening it overall, but they aren't a net benefit. Banks compete for deposits, so they're loath to pass the negative rate to customers. Some banks have reportedly started charging institutional accounts for large deposits, but they've opted to subsidize retail deposits. So they're eating fees at one end of the yield curve and settling for reduced loan revenues at the other, thanks to lower long-term rates, which shrinks net interest margins-that's bankerspeak for profits. This tricky predicament is part of the reason eurozone banks took such a pounding earlier this year.

The new TLTRO should help. By borrowing directly from the ECB, banks can cancel out much of what they're paying on excess reserves, which helps boost margins. Maybe you don't care about banks making money (bank-bashing remains quite fashionable), but profitable banks tend to lend more, and lending is the lifeblood of any economy in a fractional reserve banking system. It's how new capital is created. It's how firms big and small get the funding they need to invest and grow. The TLTRO should also further steepen the yield curve and boost liquidity throughout the financial system. One time-honored central banking trick is to drop the rate at which banks borrow from the central bank below the rate at which banks borrow from each other. That makes interbank lending more profitable, giving banks an incentive to move more money around. Unlike negative interest on excess reserves, which reduce the quantity of money, the ECB paying banks to borrow raises the quantity of money. Somewhere, Milton Friedman is smiling.

While this isn't a fix-all, it's encouraging. It's evidence the ECB realized, at least to some extent, that negative interest rates are a solution seeking a problem. Draghi sort of underscored this in his post-game presser, when he acknowledged that-while he's still a fan of negative interest rates in general-they do have some unintended consequences. Small steps to address these might be the first step in making monetary policy accommodative in more than name only.

For now, though, it's difficult to scale the overall impact, as details are scant. We know banks will be able to borrow up to 30% of eligible loans on their balance sheet, less any amount remaining from previous TLTRO rounds. There is a minimum threshold, based on a given bank's increase in eligible net lending between 1/31/2015 and 1/31/2016. Banks who undershoot that will borrow at a 0% rate, while banks that overshoot by 2.5% will get paid the 0.4%. That's a big incentive to move a lot of money and, notably, it allows banks to boost lending without imperiling their balance sheets by reducing reserves. That's huge, particularly at a time when investors are extra-wary of potential capital raises, now that they risk getting "bailed in" if a bank gets in trouble. Banks can lend more enthusiastically without risking investor flight.

Another plus: Investors seem to see this one backward. Instead of cheering the surprisingly sensible policy, they jeered Draghi for saying he's done cutting rates (which is also odd, considering how markets seem to despise negative rates in general). This creates room for any success to be a positive surprise, reducing central banking uncertainty and lifting investors' spirits in the process. That could be a nice tailwind for eurozone stocks as this year progresses.