What a difference a few weeks make. Market sentiment seems to have improved and the fears of imminent recession now appear a touch hasty. But the question of where markets head next continues to depend on policymakers’ ability to deliver bold and decisive action.
Step forward “Super” Mario Draghi, the President of the European Central Bank, who is widely expected to tinker with the euro zone’s financial plumbing this week in the face of weaker-than-expected inflation and six weeks of volatility weighing on business sentiment.
Once again, with the market already pricing aggressive action, there’s a risk of disappointment just as there was in December 2015. Analyst expectations include a 10-20 basis point cut in the deposit rate, taking it further in to negative territory, an increase of 10 -20 billion euros in monthly asset purchases, more longer-term cash available for borrowing and even a further extension in the maturity of the programme.
The problem for the ECB is that all the available options come with complications. The most immediate of those hazards applies to negative deposit rates and the impact on bank profitability and consumer behaviour, as the Bank for International Settlements highlighted this past weekend. The BIS warned that it was impossible to predict how borrowers or savers would react to the increasing possibility of negative rates for an extended period of time.
A negative deposit rate means that ordinary banks have to actually pay the ECB to deposit money, rather than receiving money as they would in a normal environment. The hope is that, instead of paying up, the banks will decide to lend the money instead. If they don’t lend, they have the choice of passing on the costs to depositors or suffer what is an effect tax on their business. And that’s at a time when profits are tough to come by.
A further complication is that it’s not just the euro zone that has resorted to negative rates, Switzerland, Denmark, Sweden and most recently Japan are all applying this monetary policy tool.
So while broader sentiment in the market recovers, I think it’s worth asking why the Stoxx Europe banks Index is still down 15 percent this year. Is this a sign that investors are growing increasingly concerned that the ECB has reached its limits and policy may now be doing more harm than good? And more importantly how cautious are the ECB?
Executive Board Member Benoit Cœuré noted in a speech on 2 March that the ECB is well aware of the issue but pointed out that ‘many (banks) have overcome negative central bank rates and the ECB’s commitment to price stability has actually supported banking profitability. A green light for more action there, I think.
No one has been more reticent about further stimulus than the Bundesbank President Jens Weidmann, who told me this month that the ECB was not a miracle-worker. And more is needed for euro zone policymakers. Yet even the German central banker drew a distinction between longer-term risks and support for the economy in the short term.
However, the declines do not seem to be associated with a global financial crisis resulting from deterioration of bank balance sheets, since credit spreads for banks have only modestly increased relative to the selloff in these stocks. Also, bank credit spreads in Europe have widened less than those in the United States, suggesting that the sharp selloff in global financial stocks is more motivated by weak earnings than weak balance sheets.
The good news is that there are ways to reduce the spillover effects of negative rates. ECB vice-president Vitor Constancio said in a speech on Feb 19th that more stimulus could be provided in a way that mitigates “the immediate, direct impact on the cost on banks,” though he added that no decision had yet been made. Analysts at Barclays, BNP Paribas and RBC capital markets have all suggested a ‘tiering’ of deposit rates could follow to help reduce the cost. Discussion of that is something to look out for on Thursday and will no doubt provide some a relief for banks investors.
Whatever Draghi decides to pull from his toolkit this week, I’m reminded of a question I asked him this time last year about the impact of extraordinary policy on the profitability of the insurance and banking sector. He acknowledged the concern but also said it was a ‘high class’ problem. The inference being that there were bigger issues to solve.
At the time I certainly agreed with him. But seven years after the crisis and with over a fifth of global gross domestic product now covered by central banks with negative rates, I think we are approaching the point where that “high-class” problem becomes a “high-cost” one.