On Thursday, ECB president Mario Draghi lowered the deposit rate on money parked at the ECB to -0.4% from -0.3%. Draghi also cut the main refinancing rate by 5 basis points to 0%.
How low can he go? Is there a limit?
There is indeed a practical limit to negative interest rate madness, and it’s likely we have already hit that limit. Let’s investigate why.
All hell would break loose if rates fell lower than -1.0%, and perhaps well before that. This has to do with Euribor.
What is Euribor?
Euribor is the rate offered to prime banks on euro-denominated interbank term loans. It is based on the average interest rates of about 50 European banks that lend and borrow from each other.
- 1 Month: -0.301
- 6 Months: -0.131
- 12 Months: -0.009
The above rates from EMMI Benchmarks. Rates change every day.
Every time the ECB cuts or raises rates, Euribor follows.
The same holds true in the US with the Fed. Interbank rates in US dollars are called Libor.
Anything over 100 represents negative interest rates. To derive futures rates subtract the value shown on the chart from 100. For example, in August of 2008, Euribor was about 5%.
How does Euribor place a Limit?
Millions of mortgages in Europe are based on Euribor. The vast majority of mortgage rates in Spain and Portugal are based on Euribor. A huge number in Italy are based on Euribor.
The typical mortgage loan in many Eurozone countries is Euribor plus 1 percentage point. For those on 1-month Euribor, the interest banks collect is no longer 1%. Instead, banks collect 0.70%. Servicing fees eat into that profit.
If Euribor fell below -1.0% banks would have to pay customers interest on their mortgages rather than collect interest!
This has already happened in some instances, primarily related to the Swiss Franc where rates are even lower.
Why Draghi Announced “No Further Cuts”
Low rates eat into bank profits. Such concerns place a floor on negative rates. This is why Draghi announced he is finished cutting rates.
The practical limit on negative interest rates in Europe may very well be -0.4%, right where we are now. Perhaps Draghi has a buffer of another -0.20% or so, but he is reluctant to use it.
If 12-month Euribor rates go any lower, it will affect bank profits on every Euribor-based mortgage loan. Loans based on 1-month and 6-month Euribor are already impacted.
Draghi is unable or unwilling to go further down the interest rabbit hole, but there are still lots of rabbit hole possibilities regarding various QE measures.
Corporate bonds still offer Draghi wide possibilities for more economic madness.
Mike “Mish” Shedlock