The ECB’s Dilemma

At today’s zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system and the economy.


Rock bottom interest rates have clearly hurt net interest margins. Whilst bank can respond by cutting deposit rates, once the policy rate hits zero, this profit-protection strategy hits a wall. A negative deposit rate would risk an exodus of out of bank deposits into cash or cash-substitutes. A deposit flight could create a liquidity crisis, forcing banks to shrink their balance sheets. Alternatively, banks could charge a higher rate to borrowers, but this would tighten credit conditions. Therefore, banks are left to take a hit to their already thin net lending margins. This also tightens credit conditions because pressure on profitability and share prices increase the cost of equity, making it harder to raise capital. Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions.

Bottom Line: The paradox is that at the zero bound, the smallest additional monetary loosening – via interest rate cuts or QE – risks stalling euro area bank credit creation. It thereby risks stalling economic growth.

EM Reflation Confirming Indicator Raises A Red Flag

With their Reflation Confirming Indicator rolling over, our EM strategists believe that it is only a matter of time until EM equities follow.


The Reflation Confirming Indicator is an equally weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation). A downturn in this indicator suggests that global reflation may subside and that demand for commodities could follow soon after. Falling commodity prices will spell trouble for EM economies and risk assets.

EM equities decoupled from our Reflation Confirmation Indicator in early 2015. Ultimately, the gap was closed by EM equities breaking lower. Continued weakness in our reflation gauge will indicate downside risks for EM assets.