Bond markets may be an option for European banks struggling with the problem of being stuffed to the gills with cash… but it’s not that simple.

In the aftermath of the financial crisis, there aren’t many borrowers, or at least, qualified borrowers, just aching to take on more debt.

This has left banks with wads of idle euros lying around, which they’re putting on deposit at the European Central Bank (ECB).

At first, this suited everyone just fine. The ECB even paid the banks interest on their deposits of excess reserves, which kept the money close at hand instead of potentially fueling runaway inflation as all of those euros got lent out.

But now things aren’t so rosy…

For the last year and a half, the euro zone’s inflation rate has fallen. Now it’s approaching zero. This is the twilight zone for bankers.

As we’ve said for many years, inflation doesn’t really scare central bankers. They believe they know how to fight it. It’s deflation that keeps them up at night.

What do you do when consumers and businesses refuse to spend at the rate you want them to? You can make loans cheaper through lower interest rates, but after that, there aren’t many options.

The Move Toward Bond Markets

Looking at fat (digital) stacks of euros, the ECB decided they needed to act, so they recently cut interest rates… to negative 0.1%. That’s right, now the central bank charges member banks to hold their cash.

The ECB did this hoping it would motivate banks to remove their excess deposits and use the funds to provide loans to businesses and consumers. The thought was that more lending would lead to more cash flowing through the economies of European countries, which would mean more euros chasing goods, and therefore rising inflation.

There’s only one problem: Charging banks to hold their excess cash does nothing to motivate consumers and businesses to borrow more money.

When it comes to credit, Europe is not facing a supply problem. There’s plenty of cash and credit available for qualified borrowers. Instead, it’s facing a demand problem. People aren’t motivated to borrow at a higher level.

To prod borrowers, the ECB would have to improve the confidence among Europeans that their businesses will receive more orders, their workers will receive higher pay, and their citizens — particularly the youth — will actually gain employment. Without these critical factors, making more funds available for lending is like putting more fuel in the tank of a car with no engine.

So what is a bank in the euro zone to do?

If making more loans is a non-starter, then European banks will have to decide what to do with their extra cash. They can keep the funds at the ECB and pay the penalty, but banks aren’t making a lot of profit these days, so ponying up for a penalty seems unlikely.

The most probable outcome is that banks will use the funds to buy securities, particularly bonds issued by euro zone countries. These bonds would require the smallest reserve requirement against loss so that banks could invest the most money.

It wouldn’t make sense to buy German bonds, which pay almost no interest. Instead, the banks will probably buy short maturity bonds of peripheral countries, particularly those that have struggled in recent years, because that’s where the yield is.

This will cause the interest rate paid on Greek, Irish, Portuguese, Spanish, and Italian bonds to drop dramatically as banks pile into the bonds issued by these countries.

What is not likely to happen is that the euro zone countries get any respite from their steady march toward outright deflation.

This trend is occurring because many countries are still dealing with the debt hangover from the financial crisis, their populations are aging and therefore want to save more not spend more, and wide swaths of European youths have no income, so they can’t spend at all.

At the end of the day, negative interest rates on excess reserves held at the ECB does nothing to change any of this.



Follow me on Twitter @RJHSDent

Strategies Fit for Today's Market

Investing is no longer a set-it-and-forget-it affair. If you’re still using that outdated approach in today’s irrational markets, you’re setting yourself up for massive losses and a difficult retirement. There’s a much… Read More>>
Rodney Johnson
Rodney works closely with Harry to study the purchasing power of people as they move through predictable stages of life, how that purchasing power drives our economy and how readers can use this information to invest successfully in the markets. Each month Rodney Johnson works with Harry Dent to uncover the next profitable investment based on demographic and cyclical trends in their flagship newsletter Boom & Bust. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. Along with Boom & Bust, Rodney is also the executive editor of our new service, Fortune Hunter and our Dent Cornerstone Portfolio.