As expected the ECB, cut its lending rate 25 basis points to 0.50%.
Yesterday, I suggested the ECB may try a “shock and awe” move. They did, just not the move anyone expected.
Instead, Mario Draghi said the ECB was Prepared to “Cope With Consequences of Negative Deposit Rates“.
Shock and Awe
Bloomberg reports Euro Falls as Draghi Open to Negative Rates; Dollar Strengthens
The euro fell for the first time in five days against the dollar after European Central Bank President Mario Draghi said policy makers may take the unprecedented step of charging banks to hold excess reserves.
“The euro was quite upbeat until Draghi made his comment that the ECB would be able to cope with any consequences of negative deposit rates,” said Daragh Maher, a currency strategist at HSBC Holdings Plc in London. “Previously, the language of the ECB on this front has characterized it as uncharted waters. Today, it seems the ECB is more open to the idea. The euro was clearly spooked by the mere concept of negative deposit rates in the euro zone.”
For an analysis of what this means, with a tip of the hat to Steen Jakobsen at Saxo Bank for the link, let’s flashback to a decision to cut the deposit rate to zero in July of 2012.
Dancing in the Dark Experiment
The Financial Times says ECB Dances in the Dark
It’s clear the ECB has gone into experimental mode.
A positive deposit rate was the last thing anchoring money market rates to zero — or vague profitability. This is because banks could arbitrage the difference between the rates they received at the ECB and the rates money market funds were able to invest at.
By cutting the deposit rate, the ECB is killing this arbitrage. There will not be any profit associated with taking money from non-banks and parking it at the ECB for a small profit. Non-banks won’t even be able to get zero.
This will leave real-rates exposed to further deterioration.
The ECB, of course, is hoping that non-banks will choose to channel that money into risky assets instead.
Death of Banking
FT Alphaville makes the case Negative rates as a precursor to the death of banking.
What we believe is that rather than stimulating the lending market — and the economy along with it — such a rate policy could have a disastrous impact on collateral markets and money market funds, not to mention the net interest income of lending institutions. All of which could unleash a protracted deflationary spiral.
The move could also presage the death of banks and lending institutions completely.
FT Alphaville cites Morgan Stanley Research as follows:
Our rates team expects short end German yields to follow financing rates into negative territory and some investors to extend along duration and credit curves to achieve positive yields to maturity.
But we do not think negative ECB deposit rates would drive any increase in cross-border interbank lending. Rather, we see a risk of greater Balkanisation of European banking markets from funding pressures.
Today, a fall in rates would hit NII and reduce banks confidence in their earnings build and capital plan – making them wish to delever more not less, although time should heal. Market liquidity is likely to fall; Bank and insurers earnings under further pressure.
In Japan, JGB trading volumes fell by 2/3 over the coming 12 years as ZIRP was adopted, particularly at the short end – one reason why the Japan Central Bank does not want front end rates to be negative. Negative rates would likely be a negative for earnings and could thus impact solvency of banks and insurers.
The greatest risk our rates colleagues see would be for negative rates 2-3 years down the curve, in which case banks would need to re-price credit further.
Morgan Stanley European Insurance analyst Jon Hocking writes: “Earnings and solvency margins for European insurers are already under severe pressure from very low long-term bond yields.”
Deposit Rate of Zero Did Not Work
It’s clear that cutting the deposit rate to zero did not work. So why will cutting them to less than zero work?
A negative deposit rate will not stimulate lending because it does not fix any structural problems, it does not fix any liquidity issues, and it makes solvency problems worse by turning guaranteed arbitrage gains into guaranteed losses on excess reserves.
Should this actually succeed in stimulating lending, expect it to also succeed at stimulating losses on that lending.
Mike “Mish” Shedlock