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6 February 2014
Going negative matters
There are three reasons why negative ECB rates can have a large impact on the euro.
First, even in a ZIRP world, the FX market remains very sensitive to short-end rates.
Running regressions across all tenors, the correlation between EUR/USD and rate
differentials is largest in the short-end of the curve. Not only that, but the beta is high - a
10bps move in yields is associated with a 3-4big figure move in the currency (chart 1).
Second, the effect on FX once the zero bound is crossed will likely be non-linear. On the
one hand, it will be the first time a major central bank "pays" investors to short the
currency. Swiss money market rates briefly turned negative in the crisis but the SNB
never charged banks for deposits. Denmark also has negative rates but this is to defend
a fixed exchange rate. If the euro becomes the first major funder with NIRP (negative
rate policy) rather than ZIRP status, portfolio shifts are likely to be larger than usual.
Third, negative rates will open up market pricing for QE. The ECB can't take rates too
negative, because at some point the opportunity cost of depositing at the ECB will be
high enough to encourage physical cash hoarding and financial disintermediation. Once
rates go negative, the next step is for the market to start pricing quantitative easing, and
rightly so in our opinion - real rates in Europe remain higher than in the US (chart 3).
Of course, for rates to go truly negative, two things will need to happen. First, the ECB
needs to release extra liquidity into the system, forcing EONIA down to the deposit rate
floor. In the absence of extra liquidity the effect would be much more limited, particularly
as LTRO prepayments would be accelerated. Second, there need to be no asterisks
attached to a deposit rate cut. If the ECB allows banks to keep excess deposits at the
unremunerated current account for instance, the de facto rate floor would stay at zero.
In sum, we think negative ECB rates are worth at least 2-3% on the currency, provided
the ECB is able to push EONIA down to a +5/-5bps range from around 10bps currently.
Even if no action materializes today and EUR/USD squeezes higher, we think the
persistent risks to European inflation and the divergence between Fed/ECB policy should
be worth at least 10 big figures of downside by year-end.
Euro Remains Very Sensitive to Short-end Yields
Implied 2yr EUR/USD yields (rhs)
The ECB Needs to Push Real Yields Lower, Like the Fed
Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13
5-yr real yields
Source: Deutsche Bank, Bloomberg Finance LP
Deutsche Bank AG/London