Negative Rates Forever

The ECB seeks to set short term interest rates in the Euro Area via control over the amount of liquidity it supplies to the banking system, as the latter is required to observe a minimum reserve requirement, in turn related to the amount of customer deposits each bank holds. The current requirement is around €140bn in aggregate and currently banks have €3,000bn deposited with the ECB, implying excess liquidity of some €2,900bn. This will generally put downward presure on money market rates but there is a floor, in theory at least, which is the ECB’s Deposit rate, which has been in negative territory for over six years now . It was cut to -0.5% last September and if money market rates fell below that banks could borrow in the market and deposit back to the ECB at -0.5%, so this potential arbitrage will generally keep rates above the Deposit rate.

The scale of excess liquidity is such that rates are very close to that floor, nonetheless, with 3 -month euribor trading at -0.486% in recent days. Indeed one money market reference rate, the euro short term rate or €STR, is trading below the Deposit rate ( at -0.54%) because it includes non-bank borrowers, unlike the conventional euribor rates.

How long will these rates last? That ultimately depends on the ECB’s perception of the inflation outlook, but judging by expectations in the money market it will be years before we see a return to positive short term rates- the market is currently pricing in a 3 month rate of -0.125% in six years time. That may not transpire of course but as it stands it implies that rates are expected to be in negative territory for well over a decade, and not the short time period envisaged by the ECB when when embarking on that policy.

Does it matter? The standard ECB argument is that negative rates are just an extension of low rates and will eventually boost credit growth, economic activity and inflation. However, negative rates have put pressure on EA bank profitability in that they have indeed helped push down borrowing costs for households and businesses but , to date, at least, most banks have been reluctant to cut deposit rates for households by a similar amount, which would take them below zero. The ECB argues that this hit to bank margins can be offset by loan growth but negative rates send a signal to potential borrowers , implying a pretty dismal economic outlook and one not conducive to productive investment spending by the private sector. Of course if one also factors in the impact of the Covid pandemic it is difficult to see an explosion in credit growth any time soon.Not surprising , then, that EA banks trade well below their equivalents in the US in terms of equity valuation, with Irish banks at around 20% of their net asset value.

There are other issues, which will become increasinly pressing if negative rates are here for the long term. The ECB can provide liquidity but can’t direct where that goes and it may simply be used to bid up existing assets such as equities and real estate. Negative rates are also a massive challenge to the long established investment model of pension funds and wealth managers. That model envisaged say a 60-40 split betwen equities ( deemed higher risk) and bonds and cash but what happens to that model when the yield on the lower risk asset is actually negative ( as is the case with many EA government bonds) and where large deposits with a bank can be charged a negative rate. In other words a fund will lose money by holding cash in a bank or by lending it to the Government. This leads to the TINA (There Is No Alternative) case for taking more investment risk so pushing up equity valuations, real estate prices and lowering the yield on high risk corporate debt.

It is hard to see how the ECB can get out of the current situation, although it does seem reluctant to cut the deposit rate again, and the implicaions of negative rates for savers are not palatable. Commercial banks may well start to cut deposit rates into negative territory for household deposits with significant implications for high savings economies such as Ireland, where household deposits and currency exceeds debt by €21bn, and where deposits in Irish headquartered banks are €37bn higher than loans. The cost of borrowing for households is low, of course, and in Ireland that mainly flows into property but that is constrained by mortgage controls, which do not apply to institutional investors..

ECB Traversing outer limits of Policy

The ECB has travelled a long way in its thinking over the last few years, and following the latest round of measures is now at the outer limits of monetary policy, with little left in its armoury. Indeed, we may be moving closer to the point where European policy makers decide that putting all the pressure on monetary policy is a mistake, and that fiscal policy has to be more active when faced with a balance sheet recession and its aftermath.

Inflation in the euro area has been below the ECB’s 2% target for some time and Draghi has often emphasized the fragile nature of the limp economic recovery but the past month has seen a much more negative perspective emerge, as crystallised in the Bank’s economic projections; growth is expected to remain below 2% for the next three years and inflation is forecast to rise to just 1.4% in 2016 from 0.7% this year. Deflation is not seen as likely but such a prolonged period of low inflation is seen to carry  the risk that expectations of sub-2% inflation become embedded.

The ECB can only directly influence very short term interest rates ( the market determines longer rates) and Europe depends heavily on bank credit to finance private sector spending ( as opposed to bond financing) so any policy levers are largely dependent on the banking sector as the transmission mechanism, with the added complication that lending rates are much higher in some parts of the zone than others. The Bank tried to address that fragmentation by providing 3-year cash to the banks in late 2011 but over half of that has been repaid and many banks used it to fund the purchase of government debt, with the result that bank lending to non-financial corporations in the euro area is still contracting. That is due in part to the economic cycle ( demand for loans is low) but the ECB has copied the Bank of England’s  Funding for Lending scheme in seeking to influence the supply of credit  via the  provision of  funds aimed directly at the private sector. Under the targeted scheme (TLTRO)   euro area banks can access funds for up to four years, starting in September, at an initial rate of 0.25%, with an initial limit of some €400bn (7% of the outstanding loan stock ex mortgages) implying a figure in excess of €5.5bn for Irish banks given the €78bn outstanding in loans to non-financial firms (the figure could be higher if one includes personal debt ex mortgages). Draghi talked about monitoring the loans but at first site the penalty for not lending to the private sector is early repayment so it is not clear how much of a stick exists alongside the carrot. Further tranches can be drawn down depending on meeting benchmark targets on net credit growth.

The UK scheme did not have a huge impact and  it remains to be seen whether demand for loans will pick up particularly in depressed economies. Banks are also due to repay some €500bn of the remaining 3-year funding although the ECB has also decided to stop sterilizing the bonds purchased under the SMP, meaning it will no longer drain the equivalent amount of money from the system. The buying of private sector debt, via Asset Backed Securities, is also on the cards, although that will take some time to organise and the market there is small.

As noted the ECB can directly affect short rates and it cut the main refinancing rate by 10 basis points to 0.15%, which  will bring some modest gains to anyone on  a tracker loan and to banks borrowing from the ECB. Lower rates may also put some downward pressure on the currency on the FX markets and to aid in that the ECB cut its deposit rate to negative territory (-0.1%) and will supply as much short term liquidity as banks demand at a fixed rate out till the end of 2016. This puts some flesh on the pledge to keep rates at current levels for an extended period and seeks to influence longer term rates in the market. The euro had weakened in the weeks before the ECB meeting in early June as traders built up  short positions in anticipation of negative rates, but has not fallen further, at least as yet, highlighting that measures that are seen to reduce fragmentation in the euro area often serve to bolster the currency.

The forward guidance issued by the ECB also now excludes any reference to even lower rates and Draghi explicitly stated that we are at the end of the line in terms of rate reductions. Consequently, the  main weapon the ECB has left is full QE, but that is unlikely to have much affect on euro domestic demand given the importance of banking credit. Hence the TLTRO but if that does not work ( and it will take some time anyway for any impact to be felt) the conclusion has to be that fiscal policy may be revisited, with the current conventional wisdom on the need for debt reduction overturned in favour of fiscal expansion. That may be a long shot now but who would have predicted  a few year ago an ECB Funding for Lending scheme, forward guidance and a refinancing rate of 0.15%?