A brief article on Bloomberg roiled bond markets this week. And yet, there wasn’t much new in the article. It said simply that a consensus had formed on the ECB Governing Council that the amount of quantitative easing (QE) purchases would be lowered in €10bn stages, once the decision had been made to close out the programme (which, by the way, is absolutely not on the agenda). That’s all. Nothing very surprising, given that probably very few people believed that the ECB would shut down QE all at once. Nor was there anything very precise, as Bloomberg’s sources asked to remain anonymous. So we are a long way from Ben Bernanke’s May 2013 “taper tantrum” speech, when he suggested that the Fed could lower its pace of purchases (the actual decision was not made until seven months later). And remember that ECB members have already stated explicitly the many measures that could be taken (including setting aside the capital key rule) but have never raised the possibility of prolonging QE while reducing its pace. If this was indeed a measure the governors wanted to take, they would certainly do better at getting the idea across.
If the markets react like that to this type of rumours it’s because the financial community is less and less inclined to accept such low or negative bond yields. It was mainly for this reason that the Bank of Japan wanted its long yield curve to be low but not negative. It is increasingly clear that central banks’ tools are reaching the limits of their effectiveness and are undeniably causing collateral damage. The impact of the low-/negative-interest rate environment on the banking sector is causing increasing concern among investors. This skepticism is reflected in banking stocks’ underperformance on financial markets. What to make of all this? First, this isn’t 2008. Euro zone banks have shored up their balance sheets considerably in recent years in order to comply with new regulatory restrictions. Average CET1 ratios of the euro zone’s largest financial institutions reached 13% by the end of 2015, vs. just 7% in 2008 (source: ECB). The European banking sector is not suffering from solvency/liquidity issues but must cope with a widespread problem of profitability. Stricter regulation, the weight of non-performing loans, and, recently, the sharp drop in interest rates have undermined banks’ ability to generate profits. The very slight slope in the yield curve is depriving banks of transformation profits between the various maturities.
The ECB denies that its ultra-accommodating monetary policy has ultimately underlined the euro zone’s banking system. Mario Draghi pointed out the positive impacts of low interest rates for banks: (1) capital gains in bond portfolios; (2) enhanced borrower solvency; and (3) increased lending volumes. The benefits of the first two impacts have partly subsided, and a race for volume to offset lower profitability would ultimately lead to an explosion in credit risk. More importantly, the ECB chairman blamed “overcapacities in the European banking sector”. In its new report on financial stability the IMF also called for in-depth reforms of the European banking sector to “to adapt to this new era of low growth and low interest rates, as well as to changes in the markets and regulations” (GFSR, October 2016). Of course, this strategy requires time and is hard to implement in the current environment.
Mario Draghi said: “Banks problems are not just a matter of low interest rates”. Let’s face it: it’s hard to imagine a central bank chairman saying anything different. But definitely are going to monitor the yield curve more closely.
Bastien Drut & Valentine Ainouz
Strategy and Economic Research at Amundi