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Negative rates, EU/UK and Brexit: ECB answers to market fears

The essential

Asset allocation: Amundi investment strategies


Many negative factors continue to weigh down the financial markets: the economic slowdown, which has been palpable for several quarters, has worsened, and has caught a far too optimistic consensus off  guard.

The central banks have been unsuccessful in easing these pressures. Worse yet, they are adding to them, with scant  leeway (the Fed) and policies that are ineffective at best (Japan) and counter-productive at worst (BoJ and ECB) - including sending long-term and short-term rates  into negative territory, which is maintaining the deflationary climate. In the United Kingdom, the date for the Brexit referendum has been announced, and now many analysts are attempting to assess the different scenarios while, politically, the rift is growing (in the UK, of course, but also within the European Union itself). Concessions made to the British are threatening European solidarity, and political Europe à la carte is tempting to many of the zone's countries. The pound has already priced in the scenario of an exit from the European Union, posting one of its steepest declines in recent memory. The many risk factors are affecting the markets, which, in many sectors, are valued at prices in line with a recession (which seems implausible to us at this stage), but bank stocks have edged close to crisis levels, and thus extreme valuations. Macro-hedging strategies should be maintained.







Since last summer, every week has brought its batch of news - taken rather badly for some time now - and we discussed some of these stories in our latest monthly issue, specifically the fears of a recession in the US, the fears of a collapse by the banking systems, the negative factors in oil's falling prices, the loss of credibility for the central banks, and the fears of a hard landing/crash landing in China.

We are going to review three specific points here: two "new" factors that have become more important in just the past few weeks, and one fundamental question:

  • The first important factor is the credibility of monetary policy, and has already been addressed time and again: it is about the ECB's lowering of deposit rates, a measure that has never found favour with us and which, also adopted by Japan, is not only ineffective, but brings many unintended consequences with it. What is the danger in staying on the path of lower interest rates?
  • The second important factor has a  direct  link  with  the  political situation in the European Union  and  the  economic  situation  in  the  UK: it is the Brexit scenario, which will be covered in a special publication (coming shortly), but about which we are just going to cover the most recent changes. What are the dangers for the European countries and the UK
  • Lastly, we will try to answer an essential question: What are the markets pricing in now? Are they prepared for the worst? Should we fear the worst? What can we expect?

I.  Sending the ECB's deposit rate into negative territory is potentially counter-productive… and stress inducing

Last November, we were - already - writing that it wouldn't be long before the decline in the ECB's deposit rates into even more negative territory would have negative effects, given the ineffectiveness of such a measure. Last December, financial markets had reacted poorly to ECB’s decisions. Why such a mistrust?

Of course it is easy to understand why the ECB wants to test the level of rates below which the banks stop holding their surplus cash at the central bank, but the question is whether it is really worth the trouble, given the risks of such  a policy. What is needed is not so much to keep lowering rates and send the entire range of rates into negative territory (as in Japan right now), but to hold rates down. If the banks have liquidities, it is precisely because the ECB is injecting them en masse, and the drop in deposit rates is penalising banks' profitability (all banks, whether in the core zone or the periphery), just when they are being shaken up by the markets and even being asked to lend more to the economy. This is a paradox, an unmistakably counter-productive one. In all, the continued decline in rates is feeding into fears of deflation more than it is fighting them (see our December edition, page 6). That is the reason why this measure cannot be adopted alone. The ECB had therefore to implement a full set of different measures, as we mentioned in our February edition. And it delivered above the most optimistic expectations :

  • The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.
  • The interest rate on the marginal lending facility will be decreased by 5 basis points t o 0.25%, with effect from 16 March 2016.
  • The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.
  • The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.
  • Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.
  • A new series of four targeted longer-term refinancing operations ( TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.

Financial markets were  enthusiastic this  time,  because these decisions are supporting low rates, low yields, peripheral spreads, corporate bonds spreads and banks. These measures nevertheless reflect (large) underlying problems, but it is impossible to neglect the positive impacts on both bonds and equities … That is why it is so important to have a look at market pricing (section 3).

II.   Brexit and Europe à la carte: an economic risk for the UK and a political risk for the EU?

It is done: David Cameron has announced the date for a referendum on the Brexit, to be held on 23 June. Different scenarios are possible, but we can still summarise the UK's potential exit with two separate options:

  • A soft exit, with all, or a majority, of the trade and financial relations between the UK and the EU upheld;
  • A hard exit, which would force the UK to revise all, or virtually all, of its agreements and relations with all of the zone's countries, one by one, and would eliminate all of the benefits that the EU has woven together with third- party countries and that the UK is currently enjoying.

As has long been the case in this subject, the polls are divided: according to a recent poll taken on 21 February, 48% of Britons are in favour of staying in, a little less than 33% in favour of exiting, and 19% of them are still undecided. Remember, since the '80s, with just a few exceptions, there are more British "Europhiles" than "Europhobes," at least in terms of the polls. Now we have to closely watch the opinion leaders’ capacity to convince - Prime Minister David Cameron (hostile to the Brexit, but has put the subject on the front burner), the Mayor of London (Boris Johnson, staunch defender of the Brexit), the (Canadian) governor of the Bank of England, Mark Carney (also hostile to the Brexit), all figures who count in public opinion, if the British press is to be believed. In addition, Cameron fears that exiting the EU would cause Scotland to seek a new referendum to leave the UK. According to Union laws ( Treaty of Lisbon, Article 50), the exit from the EU would be effective no later than two years after the UK has notified the EU that it wants to go.

How have the markets reacted? What are they now pricing in? Unsurprisingly (see risk factors, Cross Asset Monthly, November 2015), it is the British pound that has absorbed the greatest share of the shock. The recent decline is the seventh steepest drop in 25 years: significant, yes, but we have seen far worse in recent history, specifically in the 1990s with the EMS (European Monetary System) forex crises and the plummeting pound which forced the GBP out of the European Exchange Rate Mechanism on 16 September 1992.

The United Kingdom's sovereign CDS has also lost ground. It has risen nearly 20 bp and is now a little less than 40bp, the same level as France's. Still, it is lower than Spain's (which has gained 28bp since the start of the year), Italy's (+50bp), and Portugal's (+100bp).

British long-term rates have dropped precipitously, but that does not necessarily reflect the impact of a potential Brexit: in fact, GBP rates have simply followed their US and European counterparts, no more and no less.

As for equities, the decline is widespread, and the UK has done no worse than the rest of Europe.

We're not going to go into detail (that will be for the Special Focus, coming soon), but we'll just reiterate that the nature of risk varies by country:

  • For the UK, this is clearly an economic risk. A hard exit from the EU would mean the end of the European passport for its businesses. The passport gives any approved business in a Member State the option of offering its services in the territory of another Member State without being located there). Overall, according to estimates, the impact on the GDP would be significantly negative. The UK would "lose" 2.5%-9.5% of its GDP, while British employers consider that the EU, by itself, contributes 4%-5% of GDP, or about GBP 70 bn. It is easier to understand why a great majority of the business world, while divided on the subject, is nonetheless arguing to stay in the Union, or is in any event favourable to anything that is likely to avoid a hard exit.
  • For the European Union, this is primarily a political risk. The UK's withdrawal would not have any serious consequences for the Union's members (however the UK's contributions to the budget would have to be divided among the European Union countries, but given how weak the federal budget is, this does not make for any insurmountable additional charges: simply that prorated, Germany would have to take on an additional €2.2 bn, France €1.9 bn, and Italy €1.4 bn… to name only the Union's largest countries). The risk is a political one: that other European countries might extol a Europe à la carte. The lack of solidarity has been made clear along with the concessions made to the UK, with some countries declaring their interest for this or that measure granted to the UK. That is the EU's problem in a nutshell. Just recently, the EU countries granted these concessions (on immigration, sovereignty, and governance), doing whatever it takes to keep the British from leaving the Union. We are well past the time when the balance of power was the opposite; on two occasions, in the 1960s, France had vetoed the UK applications (under the MacMillan and Wilson administrations), with President De Gaulle reproaching the UK for its hostility toward the European construction and for its preferential ties to the US.

It is always crucial to look at what valuations are telling us, to get an idea of how rational they are, and whether or not they are extreme.

The money markets, and futures rates, tell us that the 3-month Euribor index could easily stay in negative territory until 2019, which does not bode well for banks' profitability. The markets are expecting more accommodating policies just about everywhere… except in the US, the UK, and Sweden. Obviously, that is important, yet at the same time, the debates over the effectiveness of monetary policy are back in force. Not surprisingly, the fixed-income markets are anticipating another 10-bp drop in deposit rates, and a curve similar to Japan's.

The foreign-exchange market, specifically on the euro, is not really counting on an extension of the QE, which should be expected to weaken the euro. Probably a mistake.

Long-term government rates have collapsed again in very recent months. Thus, in the eurozone, they have gone much lower than their break-even value. This is tied to the QE effect and to expectations of even more negative real rates. According to our models, US 10Y rates "should" be around 2.20%, very far from their current level (1.20%). Forward premiums are at all-time lows (since 1961) and are now pricing in a situation of significant deflation. As for the eurozone peripheral countries' spreads, despite the recent tensions, they are still far away from crisis peaks, and far from recession levels.

The Equity markets are showing more extreme symptoms. The MSCI World correction has now wiped out more than a year's performance. The current consolida ti on is now flirting with levels (-10% year-on-year on the MSCI World) that had only been reached during phases of the US recession (apart from 1987, a year in which the stock markets plunged but which was not followed by (was not a forerunner to) a recession). In 1987, 2000, and 2008, US PE had risen above the "20-CPI" bar, which is supposed to represent excessive valuation. In the current cycle, US PE has never reached that limit, but since the markets' decline, it is once again totally compatible with a deflation situation. It  must be said, the indices are being driven down by the energy and commodities sectors in the US, and by financial securities in Europe. European banks are in full stress: negative deposit rate, curve flattening, unique problems in Italy (bad bank), recurring fears over a large (German) bank, and so on. Even oil stocks are standing up much better in the current environment.

The PBV (price-to-book value) of European banks is (at 0.6) back near its low point of 2009 and 2011 (then at 0.5), though with much better fundamentals. The levels reached are very low, even if we consider Japan's experience. They are no longer very far from those reached during the financial crisis.

On corporate bonds, the messages diverge slightly between the US and Europe, and quite markedly between High Yield and Investment Grade. High Yield spreads are back to recession, but not crisis, levels. So they are still quite far from the peaks of the financial crisis. The "Distress Ratio" (% of issuers with spreads above 1000 bp) is also back to recession levels: 33%   in the US, and 12% in Europe. Admittedly, on US High Yield, stress and default rates are heavily concentrated on energy and basic industry (more than 70% of defaults), while on Euro High Yield, stress is visible on energy and banks. All in all, spreads of US BBB and BB-rated companies are back to 1990s and early 2000s recession levels. We might even say that  US  High Yield spreads, excluding energy, are in line with an ISM manufacturing index of less than 50… they are too high with regard to ISM service indices. Meanwhile, US Investment Grade spreads are in line with the current ISM manufacturing index, but they are high with regard to what the ISM services index shows. Here we are reminded how crucially important the gap is between the manufacturing sector (weak) and the service sector (solid). The good showing by services and consumption in the US will determine whether High Yield is properly valued or whether it is cheap.


As regard market pricing and ECB decisions, it is easy to understand why, with such extreme valuations in some cases, we still have a bias in favour of Euro assets, both bonds and equities.


ECB: a new bazooka shot






The unintended consequences of negative rates: a growing handicap




Still-undecided polls




The British pound has absorbed the greatest share of the shock




A soft exit or a hard exit?



Europe à la carte,the real danger of the EU





Eurozone: negative rates until 2019?


Peripheral spreads very far from crisis levels



Equity markets: levels compatible with a recession















Portfolio type

Equity portfolios


Bond portfolios

Divesrsified portfolios


  • Beta of portfolio around 1
  • OW Eurozone, Neutral on Japan, UW US
  • OW Techno and consumer
  • Turn neutral on oil, metals and mining
  • Emerging markets: country selection is still key within emerging markets:

-  Overweight India, Thailand, Peru, Europe, Philippines and Mexico

-  Neutral on China, Indonesia and Russia

-  Underweight Taiwan, Greece, Turkey, Brazil and Gulf countries

  • Maintain overweight position in credit vs Govies
  • Back to financials (stay selective)
  • Yield curves flattening trades
  • Emerging debt:

-  prefer hard currencies debt (long USD)

-  reduce exposure to EMG corporates

  • Maintain Long USD, JPY and INR and short GBP
  • OW Eurozone, neutral on Japan and Neutral/UW US equities
  • India our favourite amongst EMG equities... Caution on EMGs, but back gradually to commodity-producer countries
  • Prefer EUR HY and US IG
  • Keep overweight position on sovereign bonds of peripheral Eurozone countries vs. core
  • Macro hedging: long US Treasuries, long equity vol
  • Short GBP


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Cross Asset of March 2016 in English

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ITHURBIDE Philippe , Senior Economic Advisor
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Negative rates, EU/UK and Brexit: ECB answers to market fears
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