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Negative Interest Rates in Europe

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  • 11 December, 2012 GMT

By: Andrea Cohen

Last week, ECB President Mario Draghi made a very important comment regarding interest rates. While the ECB left its rate unchanged at 0.75% until the next meeting, Draghi mentioned that the ECB staff had a long and comprehensive discussion about negative rates. Negative rates are not a new concept and we see negative real rates in a few places already. In Europe, with inflation above 1%, the real rate is indeed negative already, but we assume Draghi referred to a situation of rates considerably less than zero, and not just 25-50 basis points, as it is now.

We believe that negative rates are a situation that warrants a discussion, as they can have significant impact on currency – the EUR, in this case.

First of all, we should ask ourselves, “Why negative rates?” Why should the ECB lower its rate so much that it is negative in real terms? That takes us back to the discussion on the meaning of interest rate. Interest rate is the price of money. Money is a product and comes at a price. Holding cash means that you benefit from the liquidity available to you, but on the other hand, lose the opportunity to deposit it (at the bank) and enjoy the interest it accrues. The same works in the other direction: if you borrow money from someone else (“rent” it), then you pay interest.

Interest rates are a very powerful monetary tool in the hands of central banks. Low interest rate makes depositing money and not using it an expensive proposition, as it yields low interest and on the other hand, you forgo investment opportunities that can yield higher returns. High rates offer an incentive to deposit money (save) instead of using it.

The ECB is considering lowering its rate even lower than where it is now in order to stimulate the stagnating European economy. With lower rate, banks and investors are less likely to deposit cash and are more likely to seek other investment options, meaning an injection of money into the system rather than draining it. However, wandering into negative rates territory means that the central bank is exhausting interest rates as a tool to stimulate the economy (since there is a limit to how far they can push the rates down). Think of it as shifting into first gear while driving up a hill – if the car still doesn’t pick up speed, you can’t shift the gear any lower…

So for many, cutting rates this much that even the nominal rate is negative is a sign of desperation on account of policy makers. For others it is a sign of courage – that the central bank will not refrain from even drastic and unconventional moves such as this to jump-start a slow economy.

But what will be the consequences for the EUR if nominal rates go negative?

For private people we will get a good idea in a few weeks, when the dust settles on Credit Suisse’s latest announcement. CS announced this week to its depositors that they will be charged 1% on their credit balances. That’s right – put €100 into your checking account at CS and a year from now you’ll have €99 there. We can wait and see what the reaction will be there. We assume that the reaction there will be rather mute, as retail money is quite sticky and it typically takes more than a 1% “tax” on deposits to make customers switch banks. We are also of the opinion that the negative rates will have a very small effect on consumption.

For financial institutions and corporations, on the other hand, the effect may be more noticeable. We will not make a prediction about what will happen in that arena because negative nominal rates from a huge central bank such as the ECB is something that is so distortive that such an attempt would be pure guessing. We will note, though, that while the potential upside is that banks will all of a sudden pour their reserves into the economy and that will ignite growth, the downside could be an even firmer stalemate. We know that some Money Market Funds in Europe have been avoiding taking on new money because the negative real rates make it impossible for them to even break even on their expenses.

In general, we view negative nominal rates from the ECB as a negative for the EUR. If and when such rates are announced (or if you came to the conclusion that such a decision is likely and imminent) we suggest shorting EUR and finance the position with higher-yielding “strong” currencies such as the Canadian or Australian Dollars.

DailyForex.com Team

The DailyForex.com team is comprised of analysts and researchers from around the world who watch the market throughout the day to provide you with unique perspectives and helpful analysis that can help improve your Forex trading.

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