How to Play the ECB’s Latest Surprise Move

One of the most watched events last week was the European Central Bank’s (ECB) interest rate and monetary policy decision. And while it met most of the market’s expectations, it wasn’t without surprises.

The ECB cut its benchmark interest rate by 25 basis points (0.25 percent), which was what the markets had expected. But the big news was the announcement that the ECB had cut the interest rate paid to banks on money deposited at the central bank to zero percent, from 0.25 percent.

Also in a surprise move, Denmark’s central bank cut the interest it pays on reserves it holds to a negative number, meaning that Danish banks who keep money with their nation’s central bank will have to pay to keep it there.

Will cutting rates to the bone do more harm than good?

The ECB’s latest step is a new approach aimed at getting European banks to lend the vast sums of liquidity they have on their balance sheets to each other and to borrowers — rather than hoarding it, which is what they are doing now.

The idea behind this is simple: If banks can earn a risk-free 0.25 percent return by depositing their money at a central bank, then in a zero interest rate environment like we have now, they don’t have a lot of incentive to lend it to businesses and consumers, which carry more risk.

But by cutting the interest rate the central bank pays on deposits to zero or negative, banks, in order to maintain profitability, will have to lend it to another bank, a business, or a consumer to get any return on their cash. This, in theory, should help get the flow of money going in the economy and stimulate economic growth.

There’s one problem with the theory, though …

European banks have kept money parked at the ECB and other central banks not because they love the 0.25 percent yield so much as they are afraid to lose any more capital by lending it out. These banks have kept money at the ECB out of fear, not greed. So it’s not entirely clear if removing the return will actually compel them to lend. Instead, they may be happy to ensure a return of their capital, rather than worrying about a return on their capital.

However, what is absolutely clear is that this move will reduce the European banks profitability. So, while interest rate cuts and moves to stimulate the economy are usually bullish for stocks, it might not be the case with the ECB’s move.

In fact, the case can be made that by lowering European banks profitability, European officials could actually be putting those banks in even worse financial shape as they bring in less revenue.

Being a contrarian involves looking beyond the immediate headlines and past the initial response. The moves by the ECB, which are simulative to the economy generally, are also a potential negative for the banking sector, which is at the heart of the debt crisis on that continent.

One way to play the ECB’s move is through the Pro Shares Ultra Short MSCI Europe ETF (Symbol EPV). This inverse ETF is meant to rise 2 percent for each 1 percent drop in the MSCI Europe Index. So any significant rally in European stocks off of this central bank move might provide a good entry point to buy this ETF and profit from a worsening of the crisis.

Until Europe moves to shore up that region’s banks, in particular Spanish banks, the crisis won’t be over. And while lower interest rates should help its economy, last week the ECB took one step forward and one step back.

Best,

Tom