After last December’s meeting when Mario Draghi’s announcements disappointed the market, expectations were high for the March 10th meeting. As it turned out, the markets didn’t know quite how to react. After an initial +3% rally triggered by Mario Draghi’s first comments, the Euro Stoxx closed down 1.4%. Futures continued to fall throughout the evening, only to close trading on Friday at +3.3%, after a net rebound. Aside from these short-term reactions, what can be made of Mario Draghi’s announcements in the longer term?
A series of measures that have exceeded most analysts’ expectations
1. The deposit rate was cut by 10 bps to -0.4%, and both the refinancing rate and marginal lending rate were cut by 5 bps to 0.0% and 0.25% respectively (see Figure 1).
2. The European Central Bank’s quantitative easing (QE) programme has been stepped up by 20 billion euros to 80 billion euros per month starting from April and will include non-bank investment grade corporate bonds.
3. A new series of targeted longer-term refinancing operations (TLTRO II) was announced, with one every three months starting in June 2016. Banks will be able to borrow a total amount of up to 30% of their existing loans to companies and households, excluding home loans, representing an amount nearing 1.7 trillion euros. Lending terms have been relaxed compared to previous rounds of TLTRO. Their rate is the refinancing rate, currently 0%, but depending on the amounts loaned, banks will be able to obtain a reduced rate. If banks are proven to be lending more than 2.5% by January 31st, 2018, the reduced rate will be in line with deposit rates, i.e. -0.4%. Below this figure, the rate reduction will be proportional to the improvement. In summary, the ECB will be paying banks to borrow, although let’s not forget that this is only made possible thanks to other banks’ deposits with the ECB earning negative interest.
During the press conference, Mario Draghi suggested that new rate cuts were unlikely, which probably explained the market’s reversal after an initial wave of euphoria. In fact, his full comment included the recognition that new factors could of course change the situation and outlook. That said, if new monetary easing measures prove necessary, it is more likely to be through asset purchases than via interest rate levels. For this reason, it is also unlikely that the ECB will suddenly stop its purchases in March 2017. They will be reduced gradually, and the ECB will therefore continue purchasing, which amounts to further easing.
What impact will these measures have on the Eurozone economy?
The decline in the deposit rate was widely anticipated and is now unlikely to affect short-term rates. However, the fact that the ECB did not go further will probably affect exchange rates. Against the dollar, the Fed’s monetary tightening will widen the interest rate differential and the Euro should continue to weaken versus the US currency. The ECB seems to have taken the opposite view to the Bank of Japan which emphasised negative rates as the monetary easing tool of choice. The gap between these paths opens the door to a weakening of the yen against the euro.
The increase in asset purchases will have an impact on long-term interest rates and credit spreads for corporate issuers, and hence the cost of corporate financing. The size of the non-bank investment grade corporate bond market is estimated at 480 billion euros (source Barclays) and net issuance could reach 100 billion in 2016. Even with monthly purchases in the region of 10 billion euros, the ECB is set to become a dominant player in this market, and investment grade spreads can therefore be expected to fall significantly.
The effects produced by TLTRO II remain to be seen, but the scheme’s favourable terms as compared to previous rounds, plus an improving credit market, allow room for optimism (see Figure 2). These operations should therefore enable credit improvements to strengthen, which will support investment. Despite being the least spectacular of the three measures, we believe TLTRO II will have the most significant economic impact, by boosting volumes and reducing the cost of credit.
The ECB’s teams have revised down their growth forecasts for 2016 and 2017 to 1.4% and 1.7%. They are based on data from mid-February, when market values were reflecting significant stress, which weighed on forecasts, and the ECB also mentions risks to growth in the short term. However, despite PMI type surveys deteriorating, raw data for the first quarter is very good. This is true of consumer spending (retail sales and car registrations) but even more so of industrial production: in Germany, France and Italy, December’s figures have been revised significantly upwards and strong growth was posted in January. First quarter growth figures could therefore be far better than the 0.4% consensus expectations, possibly bringing 2016 growth figures closer to the higher end of the ECB confidence interval (1.0%-1.8%).
To summarise, these measures will strengthen the credit recovery which is already underway and which we believe is the key to buoying the Eurozone’s economic recovery. Once the base effects of energy prices have waned, inflation is expected to gain pace. The ongoing improvement in the economic backdrop and the rapid decline in the unemployment rate (10.3% in January, the lowest figure since September 2011) should lead to wage strengthening and, in turn, a recovery in core inflation.
What impact will these measures have on Eurozone banks?
Overall, the ECB’s announcements will have a relatively limited impact in terms of changes in the European banking industry’s short term economic performance. However, Mario Draghi has managed to significantly improve medium-term sentiment, dissipating a real risk to the profitability of the system in terms of a steep cut in deposit rates and therefore in margins on European banks’ deposits.
Among the various announcements, we would underscore that Mario Draghi said not to expect further cuts in the rate paid on surplus cash deposited with the European Central Bank. This should help to reassure the German cooperative sector, which is highly exposed to this problem, and is also positive for southern European banks, chiefly in Spain and Italy, where variable-rate loans predominate. Indeed, the 12-month Euribor rebounded yesterday during trading. The fall in bank deposit yields is of course bad news for the sector. However, it amounts to approximately 1-2% of the sector’s earnings. We believe that this relatively modest setback for European banks’ profitability is compensated for by the near certainty that the European Central Bank should stop here. It is also for this reason that the ECB decided it wasn’t necessary to set up a mechanism that segments deposits so as to reduce the impact of the fall in the deposit rate on the profitability of the system.
The other important announcement is the implementation of a series of new TLTRO with four-year maturities. Banks in the Eurozone can now borrow at negative rates from the ECB for the first time. This should immunise European banks (see Figure 3) allowing them to refinance their bond maturities even if the conditions in the new issue market remain unfavourable.
Underlying the ECB’s move to provide cheap funds – and this is perhaps the most important signal – is what we understand to be the central bank’s genuine concern over the profitability of the banking system. Its decision also distances the threat of negative yields on retail deposits.
However, it is true that the announcement to extend the QE programme’s eligible assets to include non-speculative corporate bonds, as well as the direct impact this will have on European banks, is still unclear at this stage. Moreover, the ECB has yet to announce the proportion of the purchase programme that will be devoted to these freshly eligible assets. This could exert more pressure on the margins of major financing operations in a context where these were already decreasing. We will be paying special attention to this aspect.
In conclusion, although we do not expect these announcements to significantly affect the banking sector’s economic performance, we deem the shift in perception that they could cause as very favourable.
The European banking sector is now trading at levels almost as low as during the European sovereign crisis in 2011 or even the Lehman Brothers bankruptcy in 2008 (see Figure 4). Many fears are therefore already priced in. The momentum of sector earnings obviously remains under pressure in the short term given the very low interest rate levels. However the European recovery is underway and credit expansion is in its early stages.
While being very selective, we see current sector valuation levels as an opportunity over the medium term rather than as a negative risk.
In a world of near-zero rates, many banks are already managing to display returns close to 10%, thus covering their cost of capital. With this as a starting point, the best amongst them should improve their economic performance by working on their cost base (fewer branches, digitalisation, simplification of IT infrastructure and consolidation) on the one hand and their income streams on the other. This involves the development of fees to compensate for their interest margin erosion. However, it assumes calmer market conditions than those seen in recent weeks.
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