Why the ECB is Questioning Market Neutrality
The European Central Bank (ECB), the U.S. Federal Reserve System (The Fed), the Swiss National Bank (SNB), and the Bank of Japan (BoJ) are a few examples of some of the most well-known and closely watched Central Banks around the world.
Central Banks are in charge of overseeing a nation’s monetary policy. This is essentially how a nation controls the supply of money in order to meet certain macroeconomic goals, such as controlling inflation and growth.
The Role of the Central Bank
In order to meet their mandate, Central Banks have a variety of tools in their toolbox such as buying and selling government bonds (which affects interest rates and can aid with price stability). They have also been called “the lender of last resort” since commercial banks can lean on Central Banks when they have issues with liquidity.
Central Banks have continued to evolve and experiment with different tools in times of crisis. Quantitative easing (QE) and negative interest rates are two fairly recent examples of how Central Banks have experimented.
QE was first used in the U.S. by The Fed after the mortgage crisis in 2008, although the BoJ originally developed and implemented the concept in 2001. QE is when a Central Bank attempts to jump-start the economy by injecting money into the financial system. They do this by purchasing a large amount of government bonds or other financial securities.
Negative interest rates were first used by the SNB in 2009. Others followed, with The ECB and Germany’s Central Bank imposing negative rates in 2014 and the BOJ in 2016. Negative rates mean that banks have to pay to keep excess reserves at their Central Bank instead of the other way around. The hope with negative rates is that it is a stronger incentive for banks to lend money out to people starting businesses and taking out loans, therefore stimulating the economy.
The Concept of Market Neutrality
Central Banks are buying and selling bonds continuously. With QE, Central Banks, such as the ECB’s Asset Purchase Program (APP), may look beyond government bonds and purchase other securities, such as corporate bonds. Because Central Banks are handling massive transactions that have the potential to influence the financial market, Central Banks tend to subscribe to a concept called market neutrality to help them determine which corporate bonds to purchase. Market neutrality is a passive approach that aims to build a balance sheet of bonds that mirrors the composition of the market.
Why Market Neutrality is being Re-Evaluated
Market neutrality assumes that the market is efficient, meaning that market prices reflect all relevant and available data. The problem is that there is a glaring risk that many economists believe is not being priced appropriately into the market - climate risk. If the market is not pricing the bonds of large carbon emitters correctly, and there is concern that this is the case since companies are not required to disclose climate data and there are no consistent reporting standards, then the balance sheet of Central Bank’s will take a hit when the market eventually obtains better data and adjusts market prices accordingly.
The ECBs Christine Lagarde is leading the world in questioning the process of purchasing certain bonds in the name of market neutrality. She has expressed her increasing concern that even though the ECBs market-cap-based approach is telling The ECB to buy fossil fuel companies and large carbon emitters according to the percentage they represent in the market, that may be putting The ECB’s balance sheet at risk given The European Union’s goal of being climate neutral by 2050.
What Investors can Learn from the ECB’s Strategy Review
Christine Lagarde’s keynote speech on 25 January 2021 outlines recent changes the ECB has taken under her leadership, which include:
Doing a strategy review of the ECB’s monetary policy strategy for the first time in 17 years, of which the financial impacts of climate change has been indicated as an instigating factor,
and investing part of the ‘own funds’ portfolio in a green bond fund that is being run by the Bank for International Settlements (BIS).
Lagarde is also encouraging other Central Banks to assess if they are taking “excessive risk by trusting markets to correctly price environmental issues.” This is leading other Central Banks around the world to conduct their own sustainability reviews. While the Fed has not many any moves yet in the U.S., they joined the Network for Greening the Financial Sector (NGFS) December 15, 2020.
We will know in a few months if the ECB decides to add an additional layer of due diligence, with regards to corporate bond purchases, that take into account climate risk. Regardless, Central Banks are growing increasingly concerned that climate risk is not being priced into the financial markets appropriately. Investors should take note and work with an advisor that can help them integrate ESG factors into their investment process.
Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients nationwide and is based in San Diego. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.
Planning Within Reach, LLC (PWR) is a virtual fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.