Back in September (and on several subsequent occasions), we discussed the implications of a further cut to the ECB’s depo rate. A plunge further into NIRP-dom would have serious consequences for the Riksbank, the SNB, the Nationalbank, and the Norges Bank.
In a world dominated by beggar-thy-neighbor monetary policy, one cut begets another in a race to the bottom as everyone scrambles to, i) keep their currency from soaring and ii) keep the inflationary impulse alive.
As Barclays explained in great detail several months ago, another ECB depo rate cut would have an outsized effect of the franc:
A cut in the ECB’s deposit rate further into negative territory likely would have a significant impact on the EURCHF exchange rate and provoke a more immediate response from the SNB. Indeed, we expect that a cut in the ECB’s deposit rate may have a greater effect on EURCHF than on other EUR crosses. Switzerland applies its negative deposit rate to only a fraction of reserves, currently about 1/3rd of sight deposits by our calculation. In contrast, negative deposit rates apply to all reserves held at the ECB, Riksbank and Denmark’s Nationalbank. Consequently, a cut to the ECB’s deposit rate likely has a larger impact both on the economy and on the exchange rate than a proportionate cut by the SNB.
Now, it appears Mario Draghi may be about to go the Swiss route by introducing a tiered system for the application of negative rates. As Reuters reports, “Euro zone central bank officials are considering options such as whether to stagger charges on banks hoarding cash ahead of the next European Central Bank meeting, according to officials.”
“Officials are discussing a split-level rate,” Reuters goes on to note, adding that the “contested step would impose a higher charge on banks depending on the amount of cash they deposit with the ECB.”
"It could be combined with a ceiling, so that from a certain point onwards liquidity can only be parked overnight at a stronger rate," an unnamed official said. "Whether and how to shape a deposit rate cut in December is in discussion."
The idea would be to mitigate the effect of a more negative rate on the institutions (German and French banks for instance) that park the most cash with the ECB.
One problem with driving rates further into negative territory is that at a certain point, banks will be forced to pass along the cost to retail deposits. So far, banks have been able to avoid charging depositors by making up the cost through fees and, in what amounts to a perversion of ZIRP/NIRP, higher mortgage rates.
But, as we saw earlier this week with The Alternative Bank Schweiz, there's only so long lenders can hold out under the NIRP regime and sooner or later, negative rates will make their way to depositors. That, in turn, has the potential to cause a revolt (i.e. a bank run).
Creating a system of exemptions forestalls the application of negative rates to individual accounts and indeed, it may be the only thing keeping Swiss banks from applying NIRP across the board. As Barclays put it, "a removal of domestic banks’ exemption from negative deposit rates likely would force Swiss banks to pass on negative deposit rates as it would increase the proportion of assets charged negative rates to over 20%."
The ECB's plan "sounds like the introduction of allowances similar to that of SNB or in Denmark," Commerzbank’s Head of Fixed Rate Strategy Christoph Rieger told Bloomberg in e-mailed comments. "If allowances are set properly, the measure should fully impact rates, while still helping banks," he added.
The interesting thing about the suggestion that the ECB will adopted a tiered system is that Draghi could be telegraphing a larger (i.e. more than 10bps) depo cut. That is, if you figure out a way to mitigate the effect on banks while preserving the "boom" factor vis-a-vis rates, you'll have hit the sweet spot wherein markets will be pleasantly surprised, and banks will be able to tolerate the push further into NIRP.
"[It] allows scope for a deposit rate to be cut even more aggressively in coming months," Mizuho’s Head of Rates Strategy Peter Chatwell told Bloomberg.
"I think this could be similar to a proposal from the IMF when they were discussing negative rates for Switzerland. In essence, the ECB will have to distinguish between retail banks and the rest. They could penalize the retail banks that fund themselves via deposits a bit less so that this does not trigger a deposit flight. They could be penalizing wholesale banks a bit more given that the threat of deposit flight is less there," Credit Agricole adds.
Here's Citi's Josh O'Byrne:
Sourced indications the ECB is considering a two-tiered approach to further depo cuts suggests to us bigger cuts are being considered than Citi Economists’ 10bp base case. As we find, changing in rates are having a bigger impact on FX than they did when rates were positive. The coefficients we back out suggest a 20bp cut to a -40bp depo could take EURUSD closer to 1.04.
Worth keeping in mind here, through asset purchases there’s still about 500bn EUR of liquidity to come before now and September 2016. Increasing the term to mid-2017 would make this 1tn and increasing the pace at the same time to 80bn would put it closer to 1.5tn. Even at a -20bp depo that represents 3bn EUR of losses to the extent negative rates are not passed on to depositors and banks reduce margins.
A system which exempts a degree of deposits isn’t necessarily new and we have seen in Switzerland almost 65% of deposits exempt from negative rates using a multiple of minimum reserves. Still, CHF LIBOR has been fixing close to the -75bp, move to -80bp since expectations of ECB ease picked up. Following the very dovish speech from President Draghi last week, targeting higher inflation as quickly as possible, an ECB overwhelm looks on the cards.
Yes, an ECB "overwhelm" looks likely and that's not good news for the SNB. In a separate piece out Wednesday, Reuters notes that the Swiss are backed up against the wall. "More ECB easing would be the latest challenge in the SNB's four-year battle to shield the export-reliant economy from the strong franc," Reuters says. "I think the SNB would act if the ECB cuts rates but the room for maneuver is limited," Zuercher Kantonalbank's foreign exchange head Bernd Roth warns. The SNB's options:
- It could push three-month interbank offered rates CHLBOR=ECI, where the target range is between -1.25 and -0.25 percent,further into negative territory to maintain a spread to euro interest rates,
- it could charge more than 0.75 percent on some sight deposits at the SNB.
But Reuters leaves out the "nuclear option": removing all exemptions from the negative deposit rate. That would mean individual accounts are in danger of NIRP and it would set the stage for the proliferation of negative rates to individual depositors, a dangerous precedent to be sure.
Meanwhile, analysts are already looking at the domino effect that we've been keen on outlining since the ECB's September meeting. Nordea's Niels Christensen says "Denmark will be forced to cut below -0.75 percent" if the SNB moves after Draghi while Nomura's Yujiro Goto, Jordan Rochester contend that the Riksbank is more likely that the SNB to cut. "The Riksbank will likely to be proactive after expected ECB decision to cut deposit rate further [and there's a] high possibility of 10-15bps Riksbank rate cut," Goto said in a note on Wedensday. And let's not forget about the Norges Bank who, at +0.75 still has some room to go before NIRP if Oeystein Olsen wants to use monetary policy to combat an economy struggling with "lower for longer" crude.
So as you can see, the currency wars are alive and well and the race to the bottom (or, more appropriately, "below" the bottom) is on with the ECB set to kick off a new phase in competitive European devaluations.
It's worth noting that if the SNB's exemptions mean an ECB depo cut under the current regime would have an outsized effect of the EURCHF cross versus other euro pairs, then by definition that should mean that if Draghi introduces a tiered system, the decreased divergence between how the ECB and the SNB apply NIRP should mean less upward pressure on the franc than would have been the case with no tiered system. So consider that as well.
Finally, because all of the above was a bit technical in nature, we'll close with some comic relief courtesy of sheer central bank lunacy (via Reuters):
Another possibility raised among officials was the idea of buying bank loans at risk of non-payment. One person familiar with the matter said these could be packaged with more creditworthy loans before being put up for sale. "You could buy rebundled non-performing loans, combined with good loans," said the person. "If we get to that, then things are very bad."