FX Daily: What would a negative deposit rate really achieve?

5th June 2014

  • Richard Sharp, an external member of the BoE’s FPC, said there could be limits on the central bank’s ability to see and ease future financial shocks, noting many of the new tools at the bank’s disposal were “new and untested”. (The FT)
  • The BoJ’s Sato said he is somewhat cautious about the Japan price outlook and the bank needs allowance to target 2% inflation target. He noted the Bank is watching the waning effects of a weak yen pushing up prices and to see if nominal long-term rates are consistent with prices. (MNI Market News)
  • BoJ policymakers are encouraged by the lessening drag on the economy from the April sales tax hike but worry that a slower than expected recovery in exports could lower public expectations and hamper early achievement of stable 2% inflation. (MNI Market News)
  • Buyers are returning to the Tokyo commercial property market with a major development almost full ahead of its opening next week. The revival in Tokyo’s property market has been spurred by recent economic reforms from the Abe administration. (WSJ)
  • While global oversupply and a clampdown on the use of iron oil for financing have hit prices, China’s still-growing demand means mountains of ore are piling up at Chinese ports and are unlikely to shrink any time soon. (MNI Market News)
  • The “Big Four” state banks extended CNY270 billion in new loans in May, including CNY140 billion in the last week of the month. (Shanghai Securities News)
  • BHP Billiton has cut 100 jobs in its iron ore division headquarters in Perth as the company continues to focus on productivity. (AFR)
  • China HSBC Services PMI moderated to 50.7 in May, down from 51.4 in April. May Composite PMI rose to 50.2 from 49.5.

There was a general consensus in bond markets yesterday that any ECB policy would flop, falling well short of expectation. The US 10 year yield pushed further higher yesterday, back above the 2.6% level, its highest level in three weeks. German 10 year bunds were a similar story, pushing higher for their third consecutive day. Equity markets were on the fence. The S&P 500 reached another record high but by only 0.2% change on the day and Euro Stoxx 50 was relatively unchanged, down just -0.1%. The euro, the intended target of whatever easing is announced today, remains the wild card. The euro generally slid lower during trade yesterday, but clung on to the $1.36 level. Traders are generally short euro but cautious and in our opinion ready to profit take on a trade they have been playing for the last month. Fund managers are still feeling the pain of short EM and short yen trades which quickly soured at the start of this year. Our feeling is traders aren’t looking for another long-term currency play and looking to make a quick buck on this trade – buy the rumour, sell the fact.

At a minimum markets are priced for cuts across the entire rate corridor, including a negative deposit rate and some form of liquidity measure. The real question on the ground is what difference a negative deposit rate actually makes. Eurozone banks are flush with liquidity, hence the high level of LTRO repayment and the ECB’s shrinking balance sheet. A negative deposit rate would really only affect core Eurozone banks, whose deposits at the ECB outweigh their borrowing. Peripheral European banks would be largely unaffected. The idea is core Eurozone banks would pull funds from the ECB deposit facility for excess reserve, refusing to be charged for their deposits and try to find alternative ways to store their funds. We are not so naive as to believe that they would immediately begin to lend to their poorer peripheral cousins, especially not with an upcoming ECB AQR, but the measures should put downward pressure on broad interbank deposit rates and T-bills but only from the highest rated member states. This should bring down funding costs for the entire Eurozone banking system. However recent history has shown us that a general improvement in funding costs for banks, in tandem with heightened regulatory scrutiny, has led accelerated repayment of LTRO funds, reducing Eurozone excess liquidity and directly leading to higher Eonia rates. Negative deposit rates are not the norm for a reason and thus their effects are highly experimental. This means a policy of negative deposit rates needs to be accompanied by robust liquidity measure to prevent the measure having adverse effects.

The other way in which negative deposit rates would weaken the euro is if banks switch excess reserves to external central banks which still pay a deposit rate, i.e the Bank of England or the Federal Reserve. Banks entering cross currency swaps would put some downward pressure on the euro. However this limited impact would be far out weighted by the influx of investors into the periphery encourage by ultra-low borrowing costs and the hope that monetary easing will boost growth.

Draghi’s best bet for the capping the euro’s strength is to keep holding out the promise of more easing to come, to keep the euro bulls at pay. The only real way to correct the constrained credit environment in the Eurozone is to speed up the AQR to fix the banks or develop the market for ABS on SME loans. Both of these take time and with inflation at just 0.5% Draghi needs to do something now. All Draghi can do today is announce a filler measure to cap the euro and try to bridge the lending gap.