The introduction of negative interest rates has exacerbated financial market volatility.
01.03.2016 | 10:21 Uhr
The first two months of the year have been highly volatile for equity markets. The implementation of negative interest rates by the Bank of Japan (BoJ) and European Central Bank (ECB) has played a major role in the upheaval, hitting banks’ profitability, creating risks to the credit cycle and leading to renewed concerns about deflation. A sustained market rebound will require major policy changes.
Negative rates cause markets to plummet
The five central banks (in the euro area, Japan, Denmark, Switzerland and Sweden) who have lowered their short-term interest rates into negative territory had laudable intentions: to reflate their economies by stimulating bank lending. But it is said that the road to Hell is paved with good intentions. The implementation of negative interest rates by the BoJ and the ECB had quite the opposite result, rekindling deflationary fears through a shock to banks’ profitability.
Equity markets in Europe and Japan reacted sharply. Strikingly, the slide on stock markets steepened exactly when interest rates were pushed noticeably into negative territory. The break-point for European equities was on 3 December 2015. For Japanese shares, it came on 29 January 2016. The accelerated fall in financials in both markets dovetails neatly with the same dates.
Central banks are running out of steam
As we had feared, central banks’ monetary policies seem to be becoming less effective—or even seeing their impact reverse. Part of the reason for this abrupt shift lies in the hit from negative interest rates to the banking sector’s profitability: the cost of holding surplus reserves with central banks dents the profits of commercial banks; lending money short-term to the economy is no longer profitable; and the flattening of the yield curve erodes banks’ margins.
Added to this is central banks’ blatant failure to return inflation to their 2% target, creating doubts about their ability to revive economic growth. The fall in the price of oil, and of commodities in general, has added to concerns over deflation.
The impact of negative interest rates could disrupt the credit cycle and even cause it to reverse. Our expectations for real GDP growth of 2% in the US and 1.8% in the euro area this year depend on ongoing acceleration in lending by banks. But a slowdown can no longer be ruled out.
What is needed for a lasting rebound?
In the past few weeks, these concerns have filtered through into financial markets, which have adopted an attitude of crisis. However, economic fundamentals have shown little sign of turning for the worse. What might eradicate markets’ fears, and encourage them to readopt a more balanced view of fundamentals? Signs of at least one of three broad shifts could trigger a sustained rally:
› A lasting return in the oil price to around USD45-50 a barrel would raise inflation and lessen default risks for energy companies. But daily production needs to fall by around 1.5 million barrels to rebalance supply and demand, which will take several months.
› A reversal of monetary policies by developed-economy central banks, including a move back into positive territory for ECB and BoJ short-term interest rates. But such a shift looks unlikely in the near term.
› A strong new policy mix, including a fiscal component, to dispel deflationary pressures in the developed world. International co-operation would help too. But such a change does not seem imminent, and nothing substantive emerged from the G20 meeting on February 26-27.
In the absence of these fundamental changes, rebounds on equity markets are still possible—such as over the past week—but are likely to prove weak and short-lived. Moves in the oil price and by central banks and governments will be closely monitored. The measures already heralded by the ECB and expected in March will be key. The ECB is highly unlikely to reverse course. Indeed it might well push interest rates down further, to -0.5% by June. Nevertheless, other measures such as extension of its asset purchases, for instance to corporate bonds, could help to reassure markets, at least temporarily.
Head of Asset Allocation & Macro Research
Pictet Wealth Management