ECB Rate Cut

Rates are already negative and still no sign of growth…

The ECB decision on Thursday was actually much more dovish than the global markets had expected. The rates were cut further into negative territory while the monthly bond buying program was hiked by €20 billion to €80 billion. The markets were anticipating a rise of just €10 billion. A few things clearly emerge from the dovish rate stance of the European Central Bank.

How to get companies to borrow?

That is the big challenge for Draghi. The idea of the rate cut is that banks will now be penalized at a higher rate for maintaining deposits with the ECB. This should theoretically force the banks to lend to corporates. In practice, this never happens. The issue is not so much a supply-side problem as it is a demand-side problem. The problem is the lack of demand from companies who are unwilling to borrow and invest in the current market conditions. As long as companies are not willing to borrow, these rate cuts will have little or no impact on credit off-take. As the CFO of a leading European MNC put it succinctly, “When you do not require money, where is the need to borrow”. Ironically, falling rates are hardly relevant in this case!

Getting inflation back into EU…

The second big attempt is to get inflation back into the EU region. ECB has been consistently worried about the specter of deflation in the Euro zone. One of the arguments in favor of this rate cut is to spur spending through negative interest rates. That is again unlikely to happen as most Europeans are already enjoying the dividends of cheap oil and commodities. That has already contributed substantially to the standard of living in Europe and hence they have no incentive to increase their leverage at this point of time.

Watch for monetary divergence…

While the ECB has already spoken of no further rate cuts, the reality is that there is no further room. The damage in terms of monetary divergence may have already been done. One could see the extent of damage that was caused to the markets when the Fed hiked rates in December. Of course, the Fed does not appear to be keen on hiking rates in March, but even with static rates in the US, there is the threat of monetary divergence. That is because rates in the ECB have already gone deep into negative territory.

The big risk in the ECB strategy seems to be an increase in volatility in global markets. We saw the VIX move up sharply in January. Even assuming that the FOMC maintains status quo on March 15th, the damage in terms of divergence may have already been done. Could this lead to another bout of sharp volatility and weak global markets? Only time will tell! ©

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