ECB: Decent chance of a negative deposit rate, just not

The European Central Bank has been more outspoken about the possibility of setting a negative deposit rate, but this does not come without complications. The whole system is based on the ECB paying banks, not the other way around  Simon Smith of FxPro.  

In the interview below, Smith also assesses that the Fed will taper QE this year, and explains the drivers behind such a move. In addition discusses the prospects of more Aussie weakness, policies of Japan towards the upper house elections and future BOE policy. A lot of food for the thought.

Simon has over seventeen years experience of macro forecasting and investment strategy research. Prior to joining  FxPro  in May 2010, Simon was a consultant with Thomson Reuters, having spent four years as Chief Economist at Weavering Capital.  He has held economic and strategy positions with Standard & Poor’s, together with consultancy firms 4Cast and MMS International.  Simon holds an MSc. in Economics from the University of London and a BSc. from Brunel University.

I think it’s unlikely that we will see anything.   They cut the lending rate only last month to 0.50% and Draghi did sound a little more open to the idea of a negative deposit rate. During normal times, any banks putting any excess money on deposit at the ECB (rather than lending to other banks) receive 1% below the main lending rate.   This provides meant as a ‘penalty’ for doing so.   But the difference is now only 0.5%, so the penalty has been halved.   But adopting a negative deposit rate is not without its problems.

The whole system is based on the ECB paying banks, not the other way around, so there are logistical considerations. Beyond that, we have to see who will be punished. The risk is that the burden falls on better capitalised banks, who could be encouraged to park funds overseas.   But what’s notable is that the amount being put on deposit at the ECB continues to fall, by more than 66% since the start of the year.   Whilst this trend continues, the impact of a negative deposit rate falls the longer the ECB waits.

I still think there is a decent chance it will happen, but just not as early as June.

2. The QE tapering topic has been a significant driver of the US dollar. Do you think that the Federal Reserve could indeed lower the pace of bond buys this year? What level of monthly job gains is needed for this?

   The Fed will taper bond purchases this year.   Furthermore, the minutes have told us that the labour market will be a fairly key factor in determining when the pace of purchases are scaled back, but they have not set any numbers on this, in contrast to their pledge for an “exceptionally low range for the federal fund rate” whilst unemployment is above 6.5%.   I would think they would like to see monthly growth in headline payrolls of 200k. We are at that on the 3 and 6 month averages, but only just and the last 2 months have been below this. As such, they want to be sure that the recovery is sustainable. Too often policy makers (and even more often markets) have been caught out, expecting that the worst is over, only for expectations to see a strong turnaround, either on the back of unexpected events or otherwise.

Notionally you would have thought they would hold back on some of the more difficult structural reforms as part of their growth strategy, because they are likely to be electorally unpopular.   There will still be an element of this, but in general Abe has shown a strong willingness to push ahead, understanding that structural reforms are required if Japan is to stand any chance of achieving the growth required to pay off the debt it has accumulated over the years.   Abe has strong approval ratings and the LDP are seen doing well in July, which will give him a stronger mandate to push through such reforms.   So in summary, I think it’s going to be a balancing act, doing enough to show progress, but not so much that their solid electoral chances are jeopardised.

In the middle of the month, I certainly had the sense that the Aussie was looking over-sold, given the extent of the sell-off seen. But more recently it has turned into a US dollar story, with the greenback strong pretty much across the board and this has caused more investors to bail-out of long-term positions on the Aussie. This time last year, it was very much a story of relative sovereign fundamentals. The Eurozone crisis was deepening, there were doubts over US budgetary policy and the Aussie was benefitting from (among other things) the perception that its public finances were on a much sounder footing. The Eurozone position has improved (or at least markets are pricing this) and the US battled through the sequester. There have always been reasons to say the Aussie has been overvalued for the past several years, but it’s all a matter of timing and momentum. For now, the timing is right for a weaker Aussie and the momentum has been in place in May. There remains a risk of a modest correction, but overall the trend towards a weaker is likely to continue in the second half of the year.

Not for the moment.   Looking at the performance of the majors during May, Sterling is the first currency that has more been a victim of the firmer dollar environment, rather than a cause. In other   words, the yen, Aussie and kiwi have all had their reasons for weakening, whereas sterling has not had been subject to domestic factors pushing it lower.   The fact that we heading into a transition at the Bank of England has probably been playing a part in this, together with the fact that we are seeing some signs of stabilisation on the economy, meaning more divided opinions on the MPC between those believe the UK needs more QE (3 members voting for this over recent months) and those who believe it does not.   I don’t see any moves straight away on UK policy. Statistically, meetings 1 month before at Inflation Report (released every 3 months, including August) are the least likely to result in a change of policy, as the committee holds back to update their latest thinking. I think we will see more QE, but not straight away.

Further reading:  Market Volatility Prevalent in Japan