Quarterly Investment Strategy  

21/04/2017

Europe: Towards the end of negative rates?

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Evidence of an improved economic outlook is mounting, but electoral risk continues to hamper the performance of euro-related assets.

If political risk abates during coming months, their risk/reward profile stands to become more attractive.

European Central Bank (ECB) unconventional monetary policy would also no longer be that necessary, initiating discussions about how to remove accommodative measures.

As we have been stressing for some time, the Eurozone is no basket case. Rather, economic reports continue to reveal some surprising and encouraging truths: employment is near an all-time high, inflation is little different to other major economies (when compared on a similar basis) and some member countries figure among the world’s top-performing major economies.

With GDP (Gross Domestic Product) growth consistently above potential, survey data (manufacturing and services purchasing managers’ indices) at multi-year highs, and even the first signs of a pick-up in inflation, the monetary policy framework is evolving. From “how to fight deflation”, ECB talk is now shifting to “how and when to remove accommodation”. With deflation risks having clearly abated, and the last round of negative-rate TLTROs (Targeted Longer-Term Refinancing Operations) now concluded, the pertinence of negative deposit rates may soon be called into question.

Unlike the Fed, that never drove rates into negative territory and had a well-defined tightening sequence in mind (taper asset purchases first and only start to raise the policy rate after quantitative easing (QE) had been ended – with the final goal of shrinking the balance sheet), the ECB faces a more complicated situation. Concerns regarding the effects of negative deposit rates on the banking system may justify ending the negative interest rate policy before fully tapering the asset purchase program.

Complicating investors’ risk/reward assessment of euro-exposed assets is this year’s heavy electoral calendar on the continent. 2016 upsets in the US and UK appear to have made market participants overly cautious about European political risk, worried that Eurosceptic parties will come to power. Should this risk recede – as we expect it will – after the French elections, the combination of a solid economic performance and improving market sentiment could give the ECB the go-ahead to start discussing in earnest the process and timing of a removal of accommodative measures.

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