Our view over the past few quarters has been that EURUSD should be rangebound, as the cyclical outperformance of the US economy is offset by the eurozone’s relatively better balance of payments position. Central bank reserve diversification flows have also provided another medium-term hurdle for the US dollar.
This rangebound view was also informed by a consideration that, despite growth and inflation being weak in the eurozone, there seemed few easy options for the European Central Bank (ECB) to ease monetary policy further without potential negative side effects. The recent communication that the ECB is becoming more open to “tiering” interest costs paid on excess reserves potentially increases the chances of the ECB reducing interest rates further. Such an outcome would likely push EURUSD below 1.10.
Negative rates act as a tax on bank earnings
Excess reserves (defined by the ECB as the sum of holdings of central bank reserves in excess of reserve requirements and holdings of equivalent central bank deposits) in the eurozone currently amount to EUR 1.85 trillion. Eurozone banks currently pay ~EUR 7.4 billion per annum to hold these reserves as the ECB has currently set the rate at which it compensates excess reserves (the deposit facility rate) to -0.4%.
This effective tax on bank earnings is significant (totaling ~4% of total eurozone bank profits) although the ECB has previously argued that this cost is more than offset by an improvement in loan quality that low rates has helped facilitate. The ECB had also planned for negative rates to be temporary, as clearly indicated by its forward guidance at the start of 2019 that interest rates were set to rise in the latter months of 2019. Hence the negative impact on bank profitability was deemed manageable by the ECB.
However, we now believe the recent downturn of growth and inflation in the eurozone is changing this calculus. Markets now do not discount the first rate increase by the ECB until late 2020. The euro overnight index average (EONIA) is not discounted to turn positive until early 2023. Negative interest rates are therefore likely to be a more protracted drag on the eurozone banking sector than previously envisaged, with potentially less of the positive offsets than when the economy was in the earlier stages of the recovery.
Additionally, if recent surveys of business sentiment are accurate, economic activity in the eurozone seems poised to remain weak and this could force the ECB to ease monetary policy further. Without any offset, a further reduction in the deposit rate may yield uncertain impacts on financial and lending conditions because of the adverse impact it could have on banking sector profitability.
ECB meeting eonia forwards rates (%)
Source: Bloomberg, J.P. Morgan Asset Management; data as of 28 March 2019.
Tiered deposit rates the solution?
Recent comments by ECB officials have indicated a greater willingness to consider a tiering of interest rates at which excess reserves are compensated/charged. With tiering, as in Japan and Switzerland, only excess reserves above a certain level would pay the lowest rate of interest rate of the deposit facility while all other reserves would pay a lower cost, most likely the 0% main refinancing rate. The idea being that the ECB could reduce the effective lower bound on interest rates while minimising the impact on banking sector profitability.
There are still potential challenges with using the tiering concept. For example, it is arguable whether a further reduction in the deposit rate could lower interest rates across the yield curve, further reducing net interest margins for the banks as it is unlikely banks would be able to pass on negative interest rates to depositors. There would also be different country-level impacts to consider given the differing allocation of excess reserve levels across the region.
What would be the impact of tiering on EURUSD
We have observed over recent months the relative steepness of the euro money market curve relative to other countries and the apparent contradiction in ECB rate pricing compared to the other developed market central banks when the eurozone economy has been the epicentre of the global slowdown in activity. However, with the ECB now appearing to be more willing to embrace a tiered deposit rate system, we believe the euro money market curve can flatten and potentially invert.
In addition, the ECB has previously communicated that negative interest rates have the greatest impact on easing financial conditions via weakening the euro. It would therefore be reasonable to conclude that a further reduction in interest rates in the eurozone would be, at least in part, engineered to weaken the euro.
As a result, we believe the risks are now that we break the bottom end of the 1.12-1.18 range that has persisted over much of the past year and could even test below 1.10 if the ECB communicates a desire to lower the deposit rate in the months ahead.