Navigating the Interest Rate Environment; EU & US
Interest rates are one of the monetary policy tools that Central Banks can employ. On one side, they help economies reduce the brunt of a downturn, encouraging spending and boosting business confidence. Contrarily, they can be used to calm down any sort of inflationary pressure that seems unsustainable.
As the US embarked on a period of economic expansion off the financial crisis which lead to S&P 500 all-time highs and the longest bull market in history, the EU’s recovery has conspicuously lagged behind. In fact, as the American economy grew, the FOMC gradually rose interest rates (Fed Funds Rate) up to a 2.5% level. On the contrary, the ECB’s deposit rate went below zero in June 2014 and currently stands at -0.5%. Coupled with the Eurozone’s stagnant economic growth in the last decade, the lack of fiscal responsibility by some of its members states and, under my view, a capitalist model operating under some impractical constraints, the EU now will struggle to get back to its feet from the pandemic’s devastating hit.
Negative interest rates mean the European Central Bank charges other European banks (think Santander, Deutsche Bank) nearly half a % interest to hold their money in their deposits. This is because it wants banks to lend the money out to the economy to incentivise investment by firms and consumer spending by households, which boosts GDP and theoretically puts an economy on the path to economic prosperity. However, it seems that the move hasn’t had much success and has actually restricted the usage of monetary policy by the ECB as firepower against the economic consequences of Covid19.
Some of the EU’s member states have a very high level of debt to GDP ratios (particularly southern ones). Spain and France’s sit above 100%, Italy’s above 150% and Greece’s past 175%. This limits the ability of the Eurozone to focus on a coordinated and collective economic recovery and restrains governments from spending, hampering growth. I also believe Greece’s default in 2015 interrupted the cycle of growth, put the Euro in jeopardy and made Brussels rethink its strategy of how to aid the most disadvantaged member states. Again, another factor pushing back the Eurozone’s potential upside. A combination of these forces has seen a trend in financial services that has only intensified over time; the weighing down of EU banks in comparison to their American counterparts.
One of the most important sources of income for banks is net interest margin — the difference between the amount they pay in interest and the mount they charge borrowers. The EU’s negative interest rates has squeezed their profit margins, reducing the strength of balance sheets. This has weighed down EU banks, especially in comparison to their American counterparts. In fact, the Euro Stoxx banks gauge has underperformed the regional benchmark by over 60% since June 2014 when the ECB went negative (Bloomberg). Furthermore, interesting data shows that in the Euro area, 80% of the source of financing for the corporate sector comes from bank loans, with the rest being IG or HY bonds. In contrast, for the US, 28% comes from IG bonds rated A and above, 28% from IG bonds rated BBB, 19% from bank loans and 11% from HY bonds. The sources of finance and hence capitalisation of corporations clearly juxtaposes, exposing European corporations reliant on a poorly diversified set of funds.
As the Morgan Stanley, Bank of America or JP Morgan’s of the world have not only been able to garner income through this revenue channel but also improve their capitalisation and expand profitably, the fierce competition has had several EU banks retreat or reduce their exposure to the US. One of point of optimism for EU banks could perhaps be in loan loss provisions. American financial institutions put away $25bn whilst the EU’s number stood at approximately $16bn.
While the EU, Japan or Nordic countries like Sweden have this negative interest rate environment and other like New Zealand tout one, the Fed talked down such possibility, which is a supportive factor of the US dollar, apart from its dominating status in the world economy. Under my view, rates should be kept positive. We have seen how negative interest rate experiments in Japan or EU have not fully worked out. Their gradual increase while the economy expands seems to more optimally balance the trade-off between high rates of interest and economic growth. Furthermore, negative interest rates hurt banks, which are a key pillar of the Eurozone’s economic recovery and savers, which see their savings rate slashed.
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