ECB Preview: Unintended Consequences of Tiering (3 min read)
While the market remains focused on the headline announcements about rate cuts and the restart of QE, the ECB’s decisions on tiering and issue/issuer limits could be more important looking ahead. And here are three reasons why:
1. Rebalancing Monetary and Fiscal Policy Support
Any tiering announcement could confirm the reluctant acceptance within the ECB of the cost of negative rates for the banking system. Coinciding with significant changes in the composition of the ECB governing council it could indicate a broader policy shift.
The incoming ECB president, Christine Lagarde, has been reasonably vocal in her support for looser fiscal policy. An acceptance of limits on further rate cuts together with an increase in the limit of government bonds purchases in the QE programme could prove to be the first step in a more credible rebalancing between monetary and fiscal policy support.
2. Tiering Is Not a Panacea
The decision to introduce a tiering system might lead some investors to conclude two things. First, that the pressure of the negative policy rates on the banking system has been addressed. And second, that the effective lower bound for policy rates has shifted significantly lower.
But before jumping to conclusions, we should consider the overall impact of the various decisions taken by the ECB. Imagine the following package of measures:
- ~50% of excess reserves are made exempt from the negative deposit facility rate (DFR)
- The DFR is cut from -40bp to -60bp
- APP is restarted – a move that would increase the quantum of excess reserves going forward
- Forward guidance is strengthened – which would increase the horizon over which the DFR is expected to remain negative.
The aggregate impact of these measures even if seen only through the narrow lens of the direct cost of the negative DFR on banks might not be significant compared to the status quo. Additionally, a further decline in long-term interest rates could lead to further compression of interest margins from the asset side.
As such, the overall impact of the ECB's decisions on banks’ profitability and the potential for the ECB to take rates significantly further into negative territory might not be as clear cut as might first appear.
3. Impact of Tiering on Overnight Rates
The decision on tiering could have some interesting consequences for the very front-end of the EUR curve. By linking the exemption amount in the tiering system to a backward-looking average of excess reserves at each bank, the ECB could ease the pressure on precisely those banks that have borne the brunt of the interaction of negative DFR and excess reserves. These banks are most probably the ones able to pay negative deposit rates to non-bank financial sector depositors.
If the pressure on these banks is alleviated, there is concern it could exert upward pressure on front-end rates – especially €STR fixings, which become the effective overnight rate from early October. The upward pressure will depend on the extent to which these banks pass on the benefit of the tiering system to their non-bank financial sector depositors. However, if the marginal rate at which excess reserves are remunerated remains at the DFR and the alternative options for financial sector depositors remain limited, it is reasonable to assume that banks are unlikely to pass on the benefits of tiering. Further, even if €STR fixings do start to edge upwards it could easily be offset by the ECB being more aggressive on rate cuts going forward. Therefore, any spike in overnight rates should prove to be temporary unless there is a fundamental change in the ECB’s objective of keeping front-end rates anchored to the DFR.
Abhishek is a fixed income strategist with 12 years of experience in the developed markets rates space. His particular area of expertise is the Eurozone rates market and has worked on both the sell-side and the buy-side.
He can be contacted here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)