Ahead of the ECB’s governing council meeting on Thursday, some analysts are warning of “collateral damage” from further easing.
Barclays has argued that the future is bright for negative nominal interest rates despite challenges posed by their adverse impact on pensions and a lack of credible plans by governments to deal with this.
This year’s edition of the investment bank’s annual Equity Gilt Study comes as financial market participants debate what can be expected from the European Central Bank (ECB) this week – and further ahead.
PIMCO, for example, is expecting “a little bit more of everything” from the ECB, although it believes it is “close to exhausting its room to manoeuvre on interest rates” and may need to lean more on quantitative easing if more easing is required.
Amundi researchers, meanwhile, have suggested the ECB could be running out of leeway, warning of “increasingly significant collateral damage”, in particular because of the impact on the financial community of “too low yields”.
Valentine Ainouz and Bastien Drut, who lead strategy and economic research at the French asset manager, said: “The ECB’s ultra-loose monetary policy will not, in itself, tackle the lack of private demand in the euro-zone, and, against this backdrop, its actions to boost inflation is relatively limited.
“More than ever, one has to be very careful about the collateral damage created by these measures.”
Barclays’s analysts also discussed the limits to negative nominal interest rates as a monetary policy tool in their equity Gilts study, settling on the conclusion that the future is bright for negative nominal rates (NNR).
But this was not before they acknowledged several limits to their effectiveness and how low rates can go.
These, according to Barclays, include the “social and fiscal costs” of pension funds and insurers’ insolvency, in particular in those countries where these institutions face long-term nominal commitments.
They set out the well-rehearsed chain of events by which the introduction and progressive deepening of NNRs pushes pension funds, subject to regulatory allowances, further out the risk curve to meet their nominal obligations.
At some point, however, according to Barclays, more deeply negative rates and declining risk spreads will mean that returns even on risky portfolios will be insufficient to meet pension funds’ liabilities, which are simultaneously under pressure from lower discount rates.
Japanese 10-year bond yields recently plunged into negative territory, while their German counterparts have been approaching the zero mark.
“This process is accelerated by the existence of regulatory barriers to further risk-taking,” said the Barclays analysts.
“At that point, pensions and insurers are insolvent and need to turn to their regulator or the state either for capital injections or for contractual relief from their nominal liabilities.”
Pension institutions in this situation will probably be required to de-risk, becoming marginal sellers rather than buyers and thereby causing credit spreads and equity risk premiums to increase sharply, the analysts continued.
From a fiscal sustainability perspective, this means NNRs may increase a sovereign’s debt or lower government tax revenues, they noted.
They also suggested that, in the absence of governments “establishing credible plans to deal with the adverse impact on pensions and insurers” – and until retail NNRs become politically feasible – nominal negative rates could not go much lower than the Swedish central bank’s -125 basis point deposit rate in most economies.
In some countries, such as those with large, contingent, long-term commitments such as in Germany, rates may be unable to go even that low, they said.
“Insurers and pensions are already creaking under the strain of their nominal commitments amid historically low fixed income yields,” they said.
Still, despite this problem and other “hurdles to NNRs realising their full potential”, the analysts believe central banks will not be giving up on negative nominal rates any time soon.
“With no end to negative real rates or Missingflation in sight, negative nominal rates have – excuse the pun – a very positive future, in our assessment,” they said.