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.