ECB rate cuts and Tiering

The current 3-month euribor rate is -0.32% and the market is now firmly expecting lower  ECB rates in the near term, with a 10bp cut priced in over the next few months and a return to a positive figure not expected till the end of 2023. A combination of weaker economic data (Germany may well have contracted in the second quarter), a fall back in inflation and more dovish rhetoric from Draghi and others has convinced the market that further monetary easing is  now highly likely, as opposed to the prospect of the modest tightening signalled by the Governing Council last year.

Market measures of  Euro Area (EA) inflation expectations have also plunged , raising doubts as to whether investors have much faith in the ECB’s ability to push inflation up to the target, and a new research paper from the Bank admitted that their standard models cannot explain why inflation has undershot their forecasts of late. Nonetheless the Governing Council insists that it still has the policy instruments required. A resumption of QE is possible but the market focus has been on  rate cuts, as that would also put downward pressure on the currency,

Which rate to cut?  The refi rate is currently zero so a reduction there would take it into negative territory and would certainly have an impact in Ireland- about 40% of existing mortage holders here are on tracker rates , averaging around 1%, so they would immediately benefit. However the ECB’s deposit rate, at -0.4%, is more important in driving money market rates and a cut is more likely to emerge there. Banks in the EA have to hold reserves, determined largely by the volume of customer deposits held, but for a long time now Banks across the zone have held a massive amount of excess liquidity which in the aggregate now amounts to around €1,900bn and puts downward pressure on money market rates. The ECB’s deposit rate acts as an effective floor, therefore, and a cut would lead to lower money market rates.

So a deposit rate cut of itself would not benefit Irish Tracker mortgage holders but would probably result in a fresh round of lower fixed rate mortgage offers and  a cut in existing standard variable rates. The ECB’s negative deposit rate has other consequences however, notably in terms of dampening the profitability of EA banks. This may not be a narrative that sits well in Ireland but the Governing Council appears to have become more concerned about the potential negative  impact on bank lending from the squeeze on net interest margins .

In fact the other countries that have introduced negative policy rates ( Japan, Switzerland, Denmark and Sweden)  have also included mechanisms to mitigate the adverse impact on commercial banks, essentially by allowing far more reserves to be remunerated at  a rate well above the deposit rate, a process known as Tiering. So for example, the ECB might allow  banks to hold a multiple of their reserve requirements, say  15 or 20 times, at the main refinancing rate  and so reduce the sums being  held at the (lower) deposit rate . Of course, the trick would be to still leave enough excess liquidity to drive money market rates lower and hence ease policy. Tiering would also persuade markets that rates could be lower for longer given that the potential damage to banks has been reduced.

The EA is different from the other countries noted above, however,in that excess liquidity is not evenly distributed across the EA. In fact most is held by banks in Germany, France and the Netherlands, with little held in the periphery, including Ireland. So Tiering would certainly boost the profits of core banks but may not have much impact on banks elsewhere, again including Ireland, Indeed, if banks can now hold far more reserves at a zero rate of interest it may prompt  some selling of government bonds currently paying a negative yield as this now becomes more painful. One size  certainly does not fit all  given the fragmentation of monetary policy across the EA  which  complicates the ECB’s task and no doubt explains why they are still ruminating on Tiering and how it might best work in the euro zone.

Can the ECB do any more?

Inflation in the euro area has been below 2% now for over three and a half years, and the ECB is currently pulling four policy levers in an attempt to get inflation back up to its target level. The first is forward guidance, adopted  by the Governing Council in mid-2013, designed to convince the market that rates will stay lower for longer. The latest wording to that effect states that ‘we continue to expect [rates] to remain at present or lower levels for an extended period of time’ which also flags the possibility of further easing.

In the past the ECB has used official interest rates as its main policy instrument and they are now at historically low levels; the refinancing rate is zero while the deposit rate has been cut to -0.4%. Money market rates are also  negative , including 12-month euribor. Forward rates imply that the market does not expect any upward move in official rates till 2019.

Credit in the euro zone is largely driven by the banking sector ( unlike the US, for example)  and the ECB has also introduced additional measures to boost bank lending , including offering banks long term loans at very low rates. The latest variant (TLTRO II) offers loans up to four years at a zero rate, and banks can reduce the rate paid into negative territory depending on the growth of their loan book. So the ECB would effectively be paying banks to take funds.

Bank lending to the private sector has picked up but is still very weak by historical standards ( the annual increase is currently 1.7%) and so the ECB has sought to influence spending more directly by its asset purchase programme, the fourth policy instrument currently at play. The current plan is to purchase €80bn a month ‘until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim

Inflation is currently 0.4% and the ECB’s staff forecast envisages a gradual acceleration to an average 1.6% in 2018. The consensus market view is that further monetary easing is a virtual certainty, although there is some disagreement about the form that might take. It is noticeable that the Governing Council is now expressing more concern about the profitability of the banking system (at least in the minutes of recent meetings) and fewer analysts now expect a further rate reduction in either the refinancing rate or the deposit rate. It is early days yet for the TRLTRO so any change there is unlikely and so we are left with possible tweaks to QE, including a tapering, although, again, there are a variety of views. Some believe that the ECB may broaden the universe of assets purchased, but in reality that means buying bank debt and/or equities, which may be acceptable for the Bank of Japan but is  highly unlikely , one would think , given the ECB’s constitutional  and operational constraints.

That leaves changes to the current government bond programme, and a majority of analyts believe that the scheme will be extended beyond March, for 6 months or longer. That is not without its problems, however, as in some cases the ECB is at or close to the current 33% issue and issuer limits ( including Ireland) and at various points of late almost half  the available bonds have been trading below zero, with a smaller proportion below -0.4% in yield. A decision to leave the deposit rate unchanged would presumably preclude the latter  and a decision to up the issue and issuer  limits  could potentially give the ECB the main role in any default proceedings, an awkward position for a bank regulator. At the moment the bond purchases are also constrained by the need to adhere to the capital key ( purchases are broadly proportional to each country’s weighting in the ECB’s capital) and again a decision to abandon this may prompt opposition fror the ‘German school’ within the Governing council.

What we do know is that various committess have been set up within the ECB to tease out these matters and examine how QE could be extended if required, but the bigger issue is whether the ECB is at or near the end of its monetary policy cycle. The December Staff forecasts will be crucial and it is worth noting that oil prices are  now higher , which of itself could push the 2018 inflation forecasts to around 2%. The Council also believes its policies have had a significant effect already are are still working through the system. QE has to end at some point, one would think, and the main issue now  is whether it will be in five months or ten.

Negative Deposit rate hitting profitability of euro banks.

The ECB first cut its deposit rate to negative territory in June 2014, to -0.1%, and reduced it again late that year, to -0.2%, with a third cut taking it to -0.3% in December 2015. A further reduction was announced last month, to -0.4%, and since then criticism of the move has intensified, most notably of late from the German Finance Minister, concerned at the low return for savers.  Low and negative bond yields are putting pressure on insurance companies with products offering a guaranteed return and  the ECB’s deposit rate is particularly irksome for  the hundreds of small savings banks across the Federal Republic, given that retail deposit rates cannot fall below zero.

That squeeze on margins is not an exclusive German phenomenon, of course, and any banking system with a high dependency on retail deposits will be affected. Ironically, perhaps, banks in general have been urged to reduce their dependence on  the wholesale markets , and new Basel III rules on liquidity and funding also push banks towards deposits.

The ECB has recently responded to the criticism  by arguing that any squeeze on net interest margin  can be more than offset by higher loan growth, which the policy is designed to stimulate, and the capital gains resulting from the fall in bond yields. In that context the results of the latest  ECB Bank Lending Survey (BLS) for April is instructive, as it includes a number of ad hoc questions regarding the impact of non-standard monetary policy, including the effect of  the  negative  deposit rate. Not one  bank felt the deposit rate had a positive impact on their net interest income, with 63% stating a negative impact and another 18% a very negative effect, giving a net negative figure of 81%. Asked about the next six months, the net negative figure climbed to 85%. The vast majority of banks had seen no impact on loan volumes, although there was a small net positive, but this was offset by the negative impact on margins, so reducing overall income.

The survey also asked respondents about the impact of the ECB’s asset purchase programme, and again the results are unlikely to raise too much cheer in Frankfurt. A  small net number of banks (4%) had sold sovereign bonds as a result of QE and those experiencing capital gains in general  on assets for sales was a net positive 12% but that benefit was also more than offset by the net interest margin impact, with a net 27% seeing a fall in NIM. The result was that only 9% of banks had seen profitability rise as a result of QE, with 28% experiencing a profit fall, leaving a net decline percentage of 19%.

On the positive side QE was seen to have  improved the liquidity position of banks and  access to financing, notably via covered bonds, and the ECB has of late highlighted these metrics as a sign that  non-standard measures are working. Credit to the private sector is also finally growing again, albeit by an annual 0.9% , but for the moment at least the evidence supports the view that negative rates, in particular, are having a detrimental  effect on bank profits. It remains to be seen how that will change when the ECB’s long term loan scheme comes on stream.

 

 

 

Negative rates are a mistake

The next ECB policy meeting is scheduled for March 10th, and the market is expecting further monetary easing. This was flagged in January , when it was announced that the Governing Council would ‘review and possibly reconsider the policy stance‘  given that downside risks had risen. The minutes  show that some Council members favoured  immediate action but the consensus was to await the publication of the quarterly macroeconomic forecasts, incorporating projections out to 2018. The current forecasts envisage inflation rising from 1.0% this year to 1.6% next, but are predicated on an oil price of $52 a barrel in 2016, which looks untenable in the absence of a seismic shift in global oil supply. Headline inflation had turned positive again in late 2015 and rose to 0.3% in January but the flash reading for February was surprisingly weak, at -0.2%, with  core inflation also slowing to 0.7%.

Euro bond yields have fallen and the euro has depreciated of late in anticipation of ECB action, but the Bank has been cautious in terms of inflating expectations, mindful of the market reaction to its December announcements, which were deemed disappointing relative to what Mario Draghi was interpreted as signaling. The euro’s effective exchange rate subsequently appreciated , rising by 6% to mid-February, and speculative short positions in the euro/ dollar fell sharply. Of course there were other factors at work, including changing expectations about US monetary policy, but it is noteworthy that the ECB minutes warned against raising ‘undue or excessive expectations about policy action’ given what had happened in December.

What can the ECB do?. One option is to reduce the Deposit rate further into negative territory, as other central banks have done, The rate, currently -0.3%, is paid on overnight deposits at the ECB and  the idea is that  banks will be encouraged to lend to other banks or to use these reserves to support lending to the private sector, rather than face losses by continuing to park it with the ECB. A cut in the deposit rate, it is  also argued, will put further downward pressure on money market rates and bond yields, so precipitating a fall in the currency, which would in turn help to boost inflation.

Yet rates paid by banks to depositors are unlikely to turn negative and many loans are based on money market rates, such as 3 or 6- month euribor. Consequently negative rates hit bank margins and hence profitability. Some argue , including ECB Board Members, that this can be offset by strong lending growth but that is certainly not happening in the euro area, with the annual growth in loans to the private sector at just 0.6% in January . Consumers and firms in many countries are still reducing their debt levels (including Ireland, where net credit has been contracting now for 6 years) and on the supply side banks are building capital to meet changed regulatory requirements and are saddled with high  levels  of non-performing loans. Moreover, lending to consumers or businesses is risky and requires higher capital cover than lending to governments , where zero capital is required, particularly when the ECB is in the market buying government debt. The general public may feel that bank profitability is the least of their concerns but a healthier bank system is required if the euro area is to see stronger economic growth and negative rates will not help.

Moreover, negative rates send the signal that economic conditions are far from normal and may exacerbate the perception that monetary policy has indeed reached its limits, and may now be adding to problems rather than easing them. It is also not a given that a further rate cut by the ECB will lead to a sharp depreciation in the euro- witness the recent rally in the Yen following the bank of Japan’s move into negative rate territory- and the euro area’s huge current account surplus means capital outflows have to be enormous to push the currency lower on a sustained basis.

Conceptually, negative deposit rates, if expected to last a long time, could  also lead to a fundamental change in the financial system. Rates on cash are not negative ( excluding some storage costs ) so banks may decide to hold excess reserves in cash rather than deposit them with the central bank. Similarly, retail depositors would have an incentive to do the same thing if commercial banks sought to introduce negative deposit rates on a large scale, so threatening the main function of the banking system, the intermediation of savers and borrowers.

In sum, negative rates are not the answer and symptomatic of a refusal by central banks to accept that the emperor no longer has any clothes. Time  for Governments to take advantage of historically low or even negative bond yields and fund some sensible capital spending , which would boost demand in the short term and support higher growth further out.