Mario Draghi is a man of weighty words. His (in)famous “whatever it takes" speech in July 2012 has been referenced so many times it seems to have elevated him from economist and president of the European Central Bank (ECB) to this decade’s most quoted celebrity and saviour of the eurozone. Draghi is no Martin Luther King, but the affect that his speech had on the markets was pretty powerful. Markets rallied on the back of his bold statement and gave the economy a boost when it was nearing the point of no return.
The last month has been no exception. While the ECB's decision to cut its benchmark refinancing rate to a record low of 0.5% from 0.75% at the beginning of May came as no surprise, Draghi also proclaimed that the ECB was “technically ready” to introduce negative overnight deposit rates as it desperately tries to get banks to lend.
On the back of this statement, the euro dropped 0.9% to $1.3065 and has remained weak.
But how likely is the move?
As Marc Chandler highlights in his blog, most economists see the move as a risky idea and would do more bad than good:
| “Classic economics teaches a lower price should, all else being equal, increase demand. It seems that the financial and economic crisis is such that the low price of funds has not increased the demand, for the most part, leaving aside US C&I loans. Contracting economies, generally high levels of unemployment, and weak aggregate demand have crushed the animal spirits. |
| “A negative deposit rate would likely downward pressure on other short-term rates and exacerbate the capital preservation efforts. It would threaten profitability of a range of activities. No major central bank in the last quarter of century has done so and after a closer study we expect the ECB not to be the first to impose a negative deposit rate.” |
But this doesn’t mean we can rule out another deposit rate cut, says George Saravelos, strategist at Deutsche Bank. It's the only tool left in the box. “Negative rates in Europe are not our baseline," he says. "But the odds of a depo cut are higher than what the market is currently pricing in.” Here are his reasons why. Firstly:
| “The ECB faces big institutional constraints to policy. QE runs against European treaties and political realities. Private-sector purchases are constrained by the limited size of the ABS market and the bank-based nature of the euro financial system. The ECB is already moving to verbal guidance, but short rates are one of the few policy arsenals left.” |
Secondly:
| “Liquidity in the eurozone financial system is so unevenly distributed that sub-zero rates could have more positive effects than elsewhere. In well-functioning markets, liquidity is distributed uniformly across banks, so that excess cash always ends up at the central bank. Banks then decide between lower profit margins or passing the cost on to consumers via lending or deposit rates (e.g. Denmark). In the eurozone, excess cash is concentrated in "core" banks, while all others face a shortage. If rates turn negative, the relative attractiveness of holding cash in the periphery rises vs the core, creating a "hot potato" effect as banks try to get rid of the excess. Taking the argument to extremes, there would conceivably be a market-clearing level of negative rates that would bring Eurozone Target2 balances and market fragmentation back to zero!” |
And finally:
| “A depo cut makes more sense now than last year. Unlike December, the eurozone data is disappointing and disinflationary pressures are stronger. Unlike last summer, risk-aversion is less suggesting greater tolerance to move up the credit curve and potential for liquidity to find its way back into the periphery.” |