What a difference a few weeks make. Sentiment has improved and fears of imminent recession now appear a touch hasty. But the question of where markets head next still depends on policy-makers’ ability to deliver decisive action.
Step forward Mario Draghi, who is expected to tinker with the Eurozone’s financial plumbing this week in the face of weaker than expected inflation.
There’s a risk of disappointment a la December 2015, with the market already pricing in aggressive action. Analyst expectations include a 10-20 basis point cut in the deposit rate, taking it further into negative territory, a €10-20bn rise in monthly asset purchases, more longer-term cash for borrowing, and even a further extension in the maturity of the programme.
The problem for the European Central Bank is that all available options come with complications. As the Bank for International Settlements (BIS) has highlighted, the most immediate apply to negative rates and their impact on bank profitability and consumer behaviour. The BIS has warned that it is impossible to predict how borrowers or savers would react to the increasing possibility of an extended period of negative rates.
A negative deposit rate means banks have to pay the ECB to deposit money. The hope is that, instead of paying up, the banks will decide to lend the money. If they don’t, they face the choice of passing on the costs to depositors or suffering what is in effect a 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 ECB that has resorted to negative rates. Switzerland, Denmark, Sweden, and most recently Japan are all applying this tool. Allianz’s Mohamed El-Erian told CNBC last week that the “system is not equipped to deal with negative rates all across the world”.
So while market sentiment recovers, it’s worth asking why the Stoxx Europe Banks index is still down 15 per cent so far this year. Is this a sign investors are increasingly concerned that the ECB has reached its limits and policy may now be doing more harm than good?
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 rates and that the ECB’s commitment to price stability has actually supported banking profitability. A green light for more action, I think.
No one has been more reticent about further stimulus than Bundesbank president Jens Weidmann, who told me earlier this month that the ECB is not a miracle worker. Yet even he drew a distinction between longer-term risks and short-term support for the economy.
The good news is that there are ways to reduce the spillover effects of negative rates. ECB VP Vitor Constancio said on 19 February 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 relief for bank investors.
But whatever Draghi decides to pull from his toolkit, I’m reminded of a question I asked him this time last year about extraordinary policy’s impact on the profitability of the insurance and banking sector. He acknowledged the concern but 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 GDP covered by central banks with negative rates, we are nearing the point where that “high class” problem becomes a “high cost” one.