Macro weekly 30 october 2015

Macro Weekly

Group Economics

30 October 2015

Five questions on negative rates 

The ECB has opened the door to further rate cuts…

Head of Macro & Financial Markets



…meaning it could go further into negative territory

Research



We ask five big questions on negative rates…



…How low will they go? How low can they go? What are the

Nick Kounis

Tel: +31 20 343 5616 nick.kounis@nl.abnamro.com

benefits?...What are the negatives? What will the market impact be?

ECB could embark on more negative rates At last week’s ECB Governing Council meeting, President Mario Draghi opened the door to a further cut in policy rates, saying the central bank was considering it as an option to step up monetary stimulus. This would take the ECB’s deposit rate – which accrues on deposits commercial banks hold at the ECB – further into negative territory. This essentially means that banks will be charged more for their ‘excess’ liquidity.

The possibility of a further cut in interest rates is something the Governing Council has changed its position on. It had previously stated that the lower bound for interest rates had been reached. The ECB head explained that the situation in terms of inflation risks had changed, while the Council had also seen the experience of other countries (Sweden and Denmark for instance), which had cut rates to significantly negative levels. Given the ECB’s change in stance, we ask five big questions on negative rates that arise.

1.

How low will interest rates go?

We think it is most likely that the central bank will cut the deposit rate by another 10bp, taking it to -0.3%. However, unlike after the last reduction, we do not think that the Governing Council will signal that this is the end of the road. Indeed, we think it is more likely to leave the door wide open for further rate reductions, so the risks are skewed towards more.

Whether the ECB will need to do more will partly depend on the how the economic outlook evolves and whether the ECB judges it has done enough to get inflation back to target. Our sense is that together with an increase and extension of its QE programme, this should be the case, though there are downside risks to the outlook right now coming from the external environment.

Insights.abnamro.nl/en

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Macro Weekly – Five Questions on Negative Rates – 30 October 2015

The other factor that will determine how negative rates need to go is the evolution of the euro exchange rate. The stronger the euro, the more negative rates will need to go. The Federal Reserve is a major player in this story. After its meeting earlier this week, the FOMC signalled in its statement that it was possible that it would raise interest rates for the first time at its December meeting. This message put downward pressure on EUR/USD helping to do some of the ECB’s job for it.

If the Fed were to follow through and raise interest rates in December, that would raise the chances that the ECB’s deposit rate would not decline much further.

However, we still suspect that the Fed will delay raising interest rates until next year, given the softening data flow, emerging market risks and low inflation. If the Fed did delay and that were to lead to a sharp rise in EUR/USD, that would raise the chances of deeper rate cuts by the ECB. 2.

How low can rates go?

The ECB could most likely cut its deposit rate by much more if needed, though the exact workable trough is difficult to judge. The Danish central bank’s deposit rate has been cut to -0.75%. It has a different type of monetary policy regime to the ECB, as its main focus is managing a fixed exchange rate to the euro. However, Sweden’s central bank – which is more similar to the ECB - has gone even further. Like the ECB, the Riksbank targets inflation and the economy has a flexible exchange rate. It has reduced its deposit rate down to -1.1%. As we note below, the experiences of these central banks has been broadly positive up until now.

Negative rates in Sweden and Denmark Central bank deposit rate, %

6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 04 05 06 07 08 09 10 11 12 13 14 15 Sweden

Denmark

Source: Thomson Reuters Datastream, ABN AMRO Group Economics

Could rates go below -1.1%? Yes possibly, but here we have to go into the rather speculative realms of theory. The hurdle to interest rates going very negative is that at some point commercial banks would need to pass it on to retail deposits. If the rate on retail deposits become very negative, depositors could decide in large numbers to withdraw their money and hold it in cash instead, which would cause major problems for the banking system.

3

Macro Weekly – Five Questions on Negative Rates – 30 October 2015

Where that exact point is, is difficult to say, but a key factor is the cost of holding money securely. For instance, if the cost of storing money (in terms of security, convenience and so on) was say 2% of the total sum, that would suggest that it would still make sense for depositors to hold money at a bank up to a deposit rate of up to -2%. There are a couple of other factors that suggest the ECB’s deposit rate could go lower than the ‘cost of storing money’ level. Rates on instantly available bank deposits tend to be higher than the ECB’s deposit rate, while the rate on term deposits tends to be higher still.

3.

What are the benefits?

The main benefits of a more negative policy rate tend to be basically the same as lowering interest rates more generally. One benefit is lower bank lending rates, which could help to stimulate consumer spending and investment. The 110bp decline in the Riksbank’s deposit rate led to an 80bp fall in bank lending rates (weighted average of companies and households).

More generally, reducing interest rates into negative territory is one of the few ways to get real interest rates lower in an environment where inflation expectations have declined (which pushes up real interest rates). This may be particularly relevant given the fall in trend growth rates, which may have reduced the neutral or equilibrium real interest rate. This means that for any given real interest rate, monetary policy might be less stimulative than in past cycles, when neutral real interest rates were higher.

In addition, negative interest rates are a powerful tool to weaken a currency, which supports economic growth via exports and also pushes up inflation through higher import prices. In Sweden, the increasingly negative deposit rate has been successful in pushing down the currency (see chart below). The krona trade-weighted index has fallen by around 10% during the period of deposit rate cut from 0% to -1.1%. This is despite expectations of and actual QE in the eurozone over this period.

Riksbank deposit rate and trade-weighted exchange rate %

Index

1.5

92 90 88 86 84 82 80 78 76

1.0 0.5 0.0 -0.5 -1.0 -1.5 12

13

14

15

Riksbank deposit rate (lhs) Krona effective exchange rate (rhs) Source: Thomson Reuters Datastream, ABN AMRO Group Economics

4

Macro Weekly – Five Questions on Negative Rates – 30 October 2015

4.

What are the negatives?

Increasingly negative interest rates could lead to a profit squeeze for the commercial banking system. This is because banks might be inclined to pass on reductions in bank lending rates, but not deposit rates, for fear of losing customers if rates were to go below zero. For instance, in Sweden, the 80bp decline in bank lending rates has been accompanied by a 30bp reduction in deposit rates. This might reflect that the rate on on-demand deposits (composite households and companies) stood at just 0.07% in September. It has been at a level of 7-8bp since March, suggesting a reluctance to implement negative rates on deposits more broadly. The reluctance could wane if negative policy rates were to remain for longer, but, for now, bank profit margins may have been negatively affected.

Another cost for banks comes from storing funds at the central bank’s deposit facility at a negative rate. Commercial banks currently have EUR 170bn in the ECB’s deposit facility, so the cost of holding those funds will increase. In addition, excess liquidity will likely continue to rise as the ECB’s QE programme continues.

Having said all this, Sweden’s example is still relatively positive. Bank lending growth has continued over recent months. Although it has been modest for companies, it has been rather robust for households.

A final potential negative is the possibility that negative interest rates encourage imbalances to occur in the economy and financial markets. For instance, capital could be misallocated, while there is also a risk of asset price bubbles.

5.

What will the market impact be?

A 10bp reduction in the ECB’s deposit rate looks to already be largely priced into financial markets, so a bigger cut would be needed to have a more significant impact.

2y German government bond yields have fallen to -32bp, which is not too far from the -0.35% that they would likely settle at if the deposit rate was brought down to -0.3%.

EONIA futures also confirm the view that a 10bp reduction in the deposit rate is largely factored into financial markets. The EUR/USD – having fallen to around 1.10 – also now seems to have reacted to a deposit rate cut. The likely exceptions to this are longer maturity interbank rates (Euribor) that adjust to developments more slowly.

For instance, the 3m Euribor would probably eventually decline to around -10 to 15bp if the deposit rate is cut from around -5bp now.

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Macro Weekly – Five Questions on Negative Rates – 30 October 2015

Main economic/financial forecasts GDP grow th (%)

2013

2014

2015e

2016e

1.5

2.4

2.6

2.7

United States

-0.2

0.9

1.6

2.0

Eurozone

Japan

1.6

-0.1

0.7

1.2

United Kingdom

2.2

2.9

2.8

2.6

China

United States Eurozone

3M interbank rate

22/10/2015 29/10/2015

+3M

+12M

2015e

0.32

0.33

0.4

0.8

0.4

2016e 1.0

-0.05

-0.07

-0.15

-0.15

-0.15

-0.15

Japan

0.17

0.17

0.2

0.2

0.2

0.2

United Kingdom

0.58

0.58

0.7

1.5

0.7

1.7

22/10/2015 29/10/2015

2016e

7.7

7.3

7.0

6.5

World Inflation (%)

3.1 2013

3.2 2014

3.0 2015e

3.5 2016e

+3M

+12M

2015e

United States

1.5

1.6

0.1

1.8

US Treasury

2.03

2.17

1.9

2.5

1.9

2.6

Eurozone

1.3

0.4

0.1

1.4

German Bund

0.50

0.54

0.4

0.9

0.4

1.0

Japan

0.3

2.8

0.6

1.0

Euro sw ap rate

0.89

0.92

0.7

1.2

0.7

1.2

United Kingdom

2.6

1.5

1.1

1.9

Japanese gov. bonds

0.32

0.30

0.7

1.0

0.7

1.0

China

2.6

2.0

1.5

2.0

UK gilts

1.80

1.92

2.0

2.6

2.0

2.7

World Key policy rate

4.3 29/10/2015

3.9 +3M

3.7 2015e

3.7 2016e

22/10/2015 29/10/2015

+3M

+12M

2015e

2016e

Federal Reserve

0.25

0.25

0.25

1.00

EUR/USD

1.12

1.10

1.10

1.00

1.10

1.00

European Central Bank

0.05

0.00

0.00

0.00

USD/JPY

120.7

121.1

122

133

122

135

Bank of Japan

0.10

0.10

0.10

0.10

GBP/USD

1.54

1.53

1.53

1.45

1.53

1.47

Bank of England

0.50

0.50

0.50

1.50

EUR/GBP

0.72

0.72

0.72

0.69

0.72

0.68

People's Bank of China

4.60

4.35

4.35

3.85

USD/CNY

6.36

6.36

6.40

6.55

6.40

6.55

Source: Thomson Reuters Datastream, ABN AMRO Group Economics.

10Y interest rate

Currencies

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Macro Weekly – Five Questions on Negative Rates – 30 October 2015

Key Global Macro Events Day

Date

Time

Country

Sunday Sunday

01/11/2015 01/11/2015

02:00:00 02:00:00

CN CN

Monday Monday Monday Monday Monday Monday Monday

02/11/2015 02/11/2015 02/11/2015 02/11/2015 02/11/2015 02/11/2015 02/11/2015

02:45:00 09:00:00 09:30:00 10:30:00 15:45:00 15:45:00 16:00:00

Tuesday Tuesday

03/11/2015 03/11/2015

Wednesday Wednesday Wednesday Wednesday Wednesday Wednesday Wednesday Wednesday Wednesday

Key Economic Indicators and Events

Period

Latest outcome

Consensus

PMI manufacturing - index (official) PMI non-manufacturing (official)

Oct Oct

49.8 53.4

50.0

CN CH NL GB US EC US

PMI manufacturing - index (Caixin) Total Sight Deposits bn PMI manufacturing - index PMI manufacturing - index Markit - Flash PMI ECB announces weekly QE details ISM manufacturing - index

Oct

47.2

47.6

Oct Oct Oct F

53.0 51.5 54.0

Oct

50.2

49.9

50.0

04:30:00 16:00:00

AU US

RBA Cash Rate Target Factory orders

2.0 -1.7

2.0 -0.9

1.75

Sep

04/11/2015 04/11/2015 04/11/2015 04/11/2015 04/11/2015 04/11/2015 04/11/2015 04/11/2015 04/11/2015

02:45:00 10:00:00 10:00:00 10:30:00 14:15:00 14:30:00 16:00:00 16:00:00

CN EC EC GB US US US US PL

PMI services - index (Caixin) Oct PMI services - index Oct F Composite PMI output Oct F PMI services - index Oct ADP nat. employment report - thousands Oct Trade balance - USD bn Sep ISM non-manufacturing, index Oct Fed's Yellen Testified on Bank Regulation Before House Panel Reference rate - % Nov 4

Thursday Thursday Thursday Thursday Thursday Thursday Thursday Thursday

05/11/2015 05/11/2015 05/11/2015 05/11/2015 05/11/2015 05/11/2015 05/11/2015 05/11/2015

06:30:00 08:00:00 10:00:00 11:00:00 13:00:00 13:00:00 13:00:00 14:30:00

NL DE NO EC GB GB CZ US

CPI - % yoy Manufacturing orders - % mom Policy rate - % Retail sales - % mom Policy rate - % BoE size of asset purchase programme - GBP bn Repo rate - % Output per hour nonfarm business sector - % qoq

Friday Friday Friday Friday Friday Friday Friday

06/11/2015 06/11/2015 06/11/2015 06/11/2015 06/11/2015 06/11/2015 06/11/2015

08:00:00 09:00:00 10:30:00 14:30:00 14:30:00 14:30:00 21:00:00

DE CH GB US US US US

Industrial production - % mom Foreign currency reserves - CHF mln Trade balance - GDP mln Change in employment private employment - thousands Change in employment total - thousands Unemployment - % Fed Reserve consumer credit - USD bn

ABN AMRO

52.7

50.5 54.2 54.0 53.30 199.50 -48.33 56.9

174.90 -45.72 56.4

160

1.5

1.5

1.5

1.5

0.8 1.0 0.5

0.5

0.5

0.1 0.1

0.1

0.4

0.2

167 178 5.1 17.8

160 170 5.1

Oct Sep Nov 5 Sep Nov 5 Nov Nov 5 3Q P

0.6 -1.8 0.75 0.0 0.5 375.0 0.1 3.3

Sep Oct Sep Oct Oct Oct Sep

-1.2 541540 -3268 118 142 5.1 16.0

54.2 54.0

Source: Bloomberg, Reuters, ABN AMRO Group Economics (we provide own forecasts only for selected k ey variables and events)

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