Overall, we think interest rate changes have a diminishing effect on money creation the more negative they become. However, there are few theoretical reasons to refute that a constructive relationship will remain intact, even though there is profound uncertainty about the behaviour of borrowers and savers if interest rates were to remain significantly negative for a prolonged period of time.
The main limitation is the existence of hard cash. At some point it will become cost-effective to store deposits outside of a bank, and the longer negative interest rates are in place, the more competition will erode those costs. Even here there are plenty of interesting things that policymakers could do: large-value notes could be eliminated, pushing up the vault space required; bank notes could be taxed, making currency non-redeemable for deposits in banks; or cash could be eliminated entirely. However, we are a long way from the deeply negative rates at which these ‘wonk-tastic’ ideas might become a reality.
We are sanguine on the impact negative rates will have on bank profitability, and tentatively optimistic on the potential for negative interest rates to help the economy – particularly when considered alongside other forms of stimulus. However, European banks are far from fixed. European bank loans did not start declining until a full four years after their US peers, so substantial losses still need to be crystalised by European banks. And yet, few of these banks have managed to make a return that covers their cost of capital over the last five years.
As a result, we expect a series of mini-existential crises, triggered by rate cuts or otherwise, to continue to drive bank stock price volatility, for which investors are unlikely to be sufficiently compensated.
