After starting out strongly this morning, with DB stock trading just shy of $17/share, European banks have seen some weakness in the past hour following a report from Reuters, in which sources were cited as saying that there is "firm support for a deposit rate cut within the European Central Bank's Governing Council." While a year ago this would have sent European stocks soaring, this is no longer the case as explained by none other than Deutsche Bank last weekend:
- Declining bond yields have been robustly associated with larger inflows into bonds at the expense of equities. Though a large over allocation to fixed income at the expense of equities already exists as a result of past Fed QEs and a lack of normalization of rates, further easing by the ECB and BOJ that lower bond yields globally will only exacerbate the over allocation to bonds;
- Asynchronous easing by the ECB and BOJ while the Fed is on hold risks speeding up the dollar’s up cycle, pushing oil prices lower and exacerbating credit concerns in the Energy, Metals and Mining sectors. It is notable that the ECB’s adoption of negative rates in mid-2014 which prompted the large move in the dollar and collapse in oil prices, marked the beginning of the now huge outflows from High Yield. These flows out of High Yield rotated into High Grade, ironically moving up not down the risk spectrum. The downside risk to oil prices is tempered somewhat by the fact that they look cheap and look to be already pricing in the next leg of dollar strength;
- Asynchronous easing by the ECB and BOJ that is reflected in the US dollar commensurately raises the trade-weighted RMB and increase the risk of a disorderly devaluation by China. The risk of further declines in the JPY is tempered by the fact that it is already very (-29%) cheap, but there is plenty of valuation room for the euro to fall.
This explicit warning is one additional factor why European banks have plunged by 30% in recent weeks, and as noted earlier, have suffered such an abysmal start to the year it makes 2008 seem tame by comparison.
This perhaps also explains why Reuters adds that while a rate hike is in the works, "appetite for more radical action is still limited, conversations with policymakers indicate a month before the March rate decision."
Following DB's line of logic, one can see why Mario Draghi should be concerned: any more unconventional easing could have an increasingly more dramatic impact on bank profitability as yield curves invert ever more.
And yet the ECB has to do something (hence the problem duly noted by DB this morning): "With long-term inflation expectations falling, the ECB will probably have to act and frame the rate cut as part of broader a package, with some measures involving changes to the bank's flagship asset-purchase program, policymakers told Reuters.
But with no consensus yet about which further measures to take and Europe's modest economic recovery still broadly on track, some of those spoken to cautioned against radical action. They noted, however, that their view could still change if recent market turmoil proved lasting, posing a risk to the real economy.
Turmoil resulting from the ECB's radical actions.
More from Reuters:
ECB President Mario Draghi has said the bank would review and possibly recalibrate its stance in March to fight persistently low inflation. Markets now price at least two rate cuts, taking the deposit rate to -0.55 percent by the end of the year from -0.3 percent.
"Doing nothing in March is very unlikely," the governor of one of the euro zone's 19 central banks told Reuters. "Monetary conditions have tightened, long term inflation expectations are falling and credibility is at stake. I think a deposit rate cut is fairly undisputed."
And herein lies the rub: conditions have tightened in large part due to the ECB's actions, which means Draghi's credibility is not only at stake, but will be further reduced no matter what he does.
Finally, if NIRP is off the table, will the ECB do something else? Quite possible:
But based on the current outlook, including the increased market volatility, moving the deposit rate alone does not appear to be enough for some policymakers.
"The chance of a rate cut is high," said another governor, who spoke on condition of anonymity. "It wouldn't do enough and it would be a mistake to signal that we're relying on conventional policies when we're going to be in the unconventional sphere for years to come."
"Quantitative easing is our key policy tool and I think any package needs to have a QE component," the policymaker added.
So, in short, now that we know that banks have a revulsive reaction to more NIRP, the question is how they will react to news of more QE from a European Central Bank which has for the past year become increasingly collateral constrained. If an announcement of more QE by Draghi leads to further selling, then central banks are truly out of ammo and only monetary paradrops remain.