OP 2020: ECB folds and hikes rates

When negative deposit rates were first introduced in the euro area, the purpose was to force commercial banks to seek better returns elsewhere in order to stimulate productive investment, which would result, in theory, in higher productivity and stronger growth. So, what has happened? The investment channel hasn’t really delivered yet, and productivity is still too slow in the eurozone. Looking at key innovative sectors, such as electric vehicles, industrial robots or green investments, the monetary union is still lagging behind Asia, most notably China. 

The sad reality is that negative deposit rates certainly contributed to increase exports through the depreciation of the euro but, foremost, it also meant a disruption of financial markets and a weakening of financial and banking institutions. Negative market sentiment towards European banks largely reflects a downward revaluation of the long-term profitability outlook. Despite the recent introduction of the tiering system, which has helped to mitigate the negative consequences of negative rates, banks are still facing a major crisis. They are confronted with a challenging economic and financial environment: marked by structurally ultra-low rates, an increase in regulation with Basel IV — which will further reduce the banks’ ROE — and competition from fintech companies in niche markets. 

In an unprecedented turn of events, in early January 2020, the new president of the ECB, Christine Lagarde — who has previously endorsed negative rates — executes a volte-face and declares that monetary policy has overreached its limits. She points out that maintaining negative deposit interest rates for a longer period could seriously harm the soundness of the European banking sector. In order to force euro area governments, and notably Germany, to step in and to use fiscal policy to stimulate the economy, the ECB reverses its monetary policy and hikes rates on January 23, 2020. This first hike is followed by another a short time later that quickly takes the policy rate back to zero and even slightly positive before year-end. 

As the EU simultaneously warms up to fiscal expansion, the market reaction is surprisingly positive, and EU banks are among the best performing sectors in 2020.