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Stop Worrying: The ECB Is Not Likely to Set a Negative Deposit Rate


If the European Central Bank was going to do it, it would have done so by now.

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There has been a lot of talk about the European Central Bank (ECB) setting a negative deposit rate over the past 18 months. It's a conversation piece that has come up time and again by all ECB board members and market participants. The original argument was to spur lending, and the argument has now morphed into lowering the price of the currency by encouraging capital flight, essentially. Bottom line: I have to seriously think that if the ECB was going to set the deposit rate in the negative that it would have done it already. I think ECB board members are trying to talk down the currency. To use Japan as an example, the country has been in a period of structurally low inflation (ultimately, the central bank's mandate is inflation) for the last 20 years, and even the Bank of Japan hasn't pushed this button yet.

Personally, I have very strong conviction that the ECB will never do it. There is, at this stage, almost no incremental gain to be had from placing it in the negative, with only problems to be had. Originally, when the deposit rate was set at 0, it was done explicitly to move the 800 billion euros of European bank deposits out from the ECB and into the money markets or onto banks' balance sheets to be used for lending. Those deposits are largely gone now, with only approximately 35 billion euros left.
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The results of setting a negative deposit rate are the following:

  • Money funds will break the buck, close their doors to new deposits, or close their doors period (see here [subscription required] in July 2012 when the rate was cut to 0%).
  • Banks (Euro or international US) will begin charging large depositors to hold their cash, causing large-scale deleveraging as deposits leave Europe. A loan cannot be made without a deposit. What's the end result of that? Deflation.
  • Short-term government bill and note yields will go into the negative, which cause problems for the aforementioned money funds and banks. It will also cause capital flight into other safe government bonds such as Swiss, US, or British bonds, which will cause problems for those countries' money markets.
However, if I'm wrong, which is always possible, there's a way to play this. The spread between German 10-year bund and US 10-year Treasury yields remains at a cycle wide. If this does play out, that spread should collapse as capital makes its way into the US dollar and, by extension, US Treasuries. See the spread chart below (made with assistance from Vince Foster).
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Durable goods orders in February are still showing sideways growth -- not a good thing nor a bad thing. The negative is that "core" capital goods orders dropped, which implies (at face value) that the trend isn't up as the winter season ends. The takeaway -- let me put on my economist hat for a moment -- is that companies are still doing the bare minimum in terms of equipment maintenance and not making new investments. The recent theme has been now that companies have done enough financial engineering to shore up cash flows on their balance sheets, the next step will be to increase capex spending (for a variety of purposes), which will fuel the next growth cycle. I agree with this theory completely, but it hasn't shown up yet.
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It looks like the Treasury liquidation is over for the moment. There hasn't been a whole lot of volume conviction on this up-leg, so I remain cautious in general. I've been bullish on intermediate-duration interest rates for a trade in the context of a bear market bounce.
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There are two event risks for today and in the near future for Treasuries. The five-year auction priced today at 1:00 p.m. EDT, and there's currently an "anti-concession" and mildly overbought conditions, so the rally is probably done for today. [Author's note: The five-year auction stopped through 1.6 bps and has rallied 3 bps since 2:30 p.m. EDT, the time of this writing. I have since sold half of my position in FVM4.] Payrolls are next Friday, and all things being equal, considering where IV is for interest rate futures, there should be a volatility drift higher into that event. If there is a huge number, then there could be further destruction in the belly of the Treasury curve.

Twitter: @MichaelSedacca

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