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Investing in Europe – March 2016Negative rate policy puts strain on banks
The announcement by the European Central Bank (ECB) earlier this month to cut its interest rate further and introduce another round of targeted longer-term refinancing operations (TLTRO) clearly underlines the diverging directions of monetary policy.
While the UK is looking to eventually start raising its interest rate, the ECB has moved to negative rates and has embarked upon further quantitative easing (QE).
Christopher Meurice, associate director at Signia Wealth, notes: “The commitment towards liquidity and easy financing over blunt negative interest rates is arguably a strong positive signal.
“There is evidence that the opening phases of negative interest rate policy (NIRP) are beneficial to credit growth, but subsequent deepening of negative interest rates is seen as severely detrimental to bank profitability.”
This potential risk to the banking sector is also highlighted by Hugh Cuthbert, manager of the SVM Continental Europe fund, who points out the ECB measures may not have the desired effect.
He says: “You could ask what on earth [Mario] Draghi was thinking cutting rates at this moment in time? The strain negative interest rates put on the banking system – making it increasingly difficult to make money – could have the opposite impact to what policy stimulus is designed to achieve.
Stability of the banking sector is essential to give investors faith in the European economy Hugh Cuthbert“The introduction of TLTRO mark II however was a very clever move, prompting a strong market rally. Giving banks access to cheap money from the ECB negates the potential nightmare scenario of negative interest rates.
“TLTRO is a safety net for the banking sector and will save the banking sector and economy from the worst case scenario. Without it we could have seen a dangerous spiral with banks struggling to make any money. Stability of the banking sector is essential to give investors faith in the European economy and avoid a return to 2011, or even 2008,” he adds.
The ECB is not the only central bank in Europe, with the Swiss National Bank (SNB) making its presence felt last year when it ended the Swiss franc’s peg to the euro, while expectations around the Bank of England (BoE) are more in line with US monetary policy with an interest rate hike anticipated within the next year.
| ECB’s LATEST MOVES |
On March 10 2016 the ECB announced the following monetary policy decisions: • The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0 per cent, starting from the operation settled on March 16. • The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25 per cent, with effect from March 16. • The interest rate on the deposit facility will be decreased by 10 basis points to -0.40 per cent, with effect from March 16. • The monthly purchases under the asset purchase programme will be expanded to ¤80bn starting in April. • Investment grade euro-denominated bonds issued by non-bank corporations established in the eurozone area will be included in the list of assets that are eligible for regular purchases. • A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility. |
“The market is therefore awaiting the first tightening move but acknowledges there is no urgency, as economic data has been weak despite moving in the right direction.
!In the coming months, it will have to consider the impact of a potential Brexit on domestic growth and the currency, the latter of which has been weakening substantially this year.
“The SNB has taken a step back from headlines since it removed the Swiss franc/euro peg in early 2015, maintaining interest rates at their record lows rather than easing further.
“However, it will potentially be more active in the currency markets going forward. [SNB chairman] Thomas Jordan is threatening to ‘intervene in currency markets’ if necessary, as he sees an overvaluation of the Swiss franc as the dominant issue facing the economy.”
But with the ECB, and also Japan, moving to NIRP and with QE already on the table, what tools are left in the arsenals of central banks?
Richard Smith, investment manager at Mattioli Woods, points out: “The recent announcement by [Mr] Draghi suggested that we were unlikely to see rates become ‘even more’ negative after the most recent cut. This doesn’t mean that the unprecedented experiment is over.”
He warns: “The ECB’s focus seems to have moved from engaging in further currency devaluation to more inventive means of getting the banks to lend more and stimulate demand in this way. But do the banks want to lend more money in this uncertain environment?
“And should a central bank really be buying investment-grade bonds as it was announced it would do? Wherever next for asset purchases – equities? The suggestion from some commentators is that this could ultimately happen.”
Mr Smith points out this has resulted in an investment universe where valuations are stretched across asset classes and correlations between them are high.
He adds: “Monetary policy has pushed investors to search for returns in risk assets in which they are not naturally at home, creating an additional vulnerability for markets. We are engaged in an unprecedented economic experiment and normalisation looks some way off.
“If investors are looking for reassurance, it is best found in the observation that having staked so much on manipulating asset prices for so long, it is difficult to see central banks changing course too abruptly.”
| EUROPEAN MONETARY POLICY – EXPERT VIEWS |
Christopher Meurice, associate director at Signia Wealth, says: “The main event for European monetary policy was undoubtedly the ECB’s announcement on March 10 2016. Mario Draghi announced a deposit rate cut of 10 basis points from -0.3 per cent to -0.4 per cent, a rise in bond purchases to €80bn [£62.8bn] per month from April this year, an expansion of QE to include corporate bonds, and adjustments to TLTRO refinancing. “It is worth noting all these measures were announced simultaneously, despite several only becoming active at the end of the second quarter. This move away from Mr Draghi’s usual approach of keeping his powder dry until absolutely necessary is potentially a reaction to ECB growth forecasts being revised significantly down, from 1.7 per cent to 1.4 per cent for 2016 GDP growth. “It is likely the ECB will concentrate on unconventional methods to provide liquidity directly to the markets and will avoid further negative rates after the lessons learnt by the Bank of Japan in recent months. It will also aim to improve the efficacy of its actions to counteract the perceived diminishing returns of monetary policy action as confidence in the ammunition available to central banks is paramount for their continued function.” Serge Pepin, investment strategist at BMO Global Asset Management, EMEA, comments: “The ECB has certainly been front and centre when it comes to its accommodative monetary policy. However, it has not been the only central bank within Europe that has trimmed key lending rates since the financial crisis of 2008. “The central banks of Denmark, Norway, Sweden and Switzerland have all eased their monetary policies. It appears that the Bank of England has its key lending rate glued to the floor for some time to come, especially with the uncertainty surrounding the June 23 referendum. Setting itself apart from the rest of the crowd, a marked rebound in the Icelandic economy saw the country’s central bank Sedlabanki hike its main interest rates. “The rate cuts are all in response to the slow progress in economic activity and low inflation. We expect the accommodative stances of the ECB and those outside the euro area to continue for some time.” |
Nyree Stewart is features editor at Investment Adviser
