ECB – Why Negative Interest rates?

We know that the currency market and in fact all markets are driven by future interest rates. Interest rates are a tool to manage the growth of the economy. Each piece of micro data adds to the interest rate story.

In recent years the global growth has been difficult to stimulate. The mandate for most central banks is to manage inflation and to have a stable financial system. The cash rate set by the central bank is the rate at which retail banks lend money to each other. The banks will have their profit mark up passed onto the end customer.

Understanding the Market

As volatility retail traders, we do not have to understand the inner workings of a central bank. However to understand the market we do need to have a broad brush understanding of the drivers. We need to know if the FED is hinting to raise rates again or reduce rates. When a central bank makes a shift in policy, you need to know. Understanding the market takes time and discipline. If you are reading this article then it is a way for you to improve your understanding of the market. 

Keep in mind, our role is not to predict what the central bank will or will not do. Yes, an opinion is fine but do not be married to the opinion. We are also not predicting how the market will respond.

Why Negative Interest rates?

The purpose of negative interest rates is to increase inflation and growth. To increase inflation, spending is needed. People can borrow at much lower rates which encourages spending. This is known as cheap money.

If a large company can borrow at a very low rate, invest into infrastructure, expansion, create jobs etc, then this will create growth thus inflation. Naturally the biggest fear for the central bank is deflation. The central bank will do almost anything to avoid deflation of it's economy.

Negative interest rates are a sign of pure desperation from central banks. it is like the last party trick when nothing else works.

The Negative to Negative Interest Rates

Banks need to hold deposits from you and me. Banks have minimum deposit requirements which determines their ability to lend. Retail banks lend out more than what they have, this is the power of fractional banking.

This creates an interesting situation for banks. They need to attract deposits in order to lend, however negative rates means the depositor need to pay the bank to hold their money.

The entire concept of negative rates or low rates in to encourage people to spend to create growth and spur on inflation.

One Crucial Consideration

For those that are in a financial position or are in a spending cycle within their life, what must you have? You need to have confidence. You need to feel some wealth factor, certainty about your job. Confidence in your economy will encourage you to buy a new car, upgrade your property, buy an investment property, expand your business etc.

Self funded baby boomers will not want to extend their financial commitments due to the low interest rate returns offered to them from the banks due to negative interest rates. They have however been lucky enough to have in recent years a good stock market with good dividends. They do not have confidence to be easy with their wealth.

Euro zone - TLTRO III

In a matter of hours we are about to have TLTRO III announced by the ECB. The most recent TLTRO was in 2016 during the Euro debt crisis. Back then the ECB deposit rate was -0.4%. The Euro zone has moved on since then and the situation for the region has improved. There has been some growth however their are still many headwinds ahead for the Euro zone. Trade wars are at play, Brexit is still dragging out and global growth is terrible.

When you see the term TLTRO III, just think the word "stimulus". 

How can I use this in my Trading?

As a trader, we need to be listening for shifts from the central banks. Let us assume that in 12 months from the installation of TLTRO III, we started to see some consistent growth come out of Europe. The central bank might start communicating a positive picture for the Euro zone. This would start to translate to less stimulus and at some point an increase in interest rates and less bond buying from the ECB.

The situation explained above would be positive for EUR. We would also need to know what the FED was thinking.

Currently the EURUSD is trading near 1.1200. This is on the back of a FED that has been hiking rates and a ECB that has been stimulating the market. Less than 12 months prior the EURUSD was trading at 1.1800. This was on the back of ECB signaling rate increases at some point in the near distant future. This never happened.

The micro data such as PMI's, employment, retail sales, CPI etc are drip feeding into price. Listed to what the central banks are saying. All this combined will lead to interest rate changes and this is what the market cares about.

Clarity for EURUSD Pair

As I mention in the Mastering EURUSD Course https://eurusd-fxtrader.com/price-action-trading-course/ the EURUSD pair gives us two central banks with clear communication. Central banks do not want to shock the markets and will drip feed the market information relating to interest rates. Most often by the time an interest rate adjustment has been made, the change has already been priced in. This is why the press conference or meeting minutes are crucial as this is where the next direction on interest rates are coming from. 

USD is the backbone

The United states has a very big advantage. The advantage is that it owns the reserve currency of the world. More than 80% of all trade transactions are completed with USD. This makes the USD king. There will be a shift at some point in time, there always has been but for now it is the USD. If you own the worlds reserve currency, you have a very big advantage.

As traders we need to track the USD strength and weakness. This will determine flows in and out of currency pairs. By understanding the interest rate situation for your specific trading pair, you will also have an advantage. 

The more you can understand the market, the more success you will have. Do keep this in mind, the market does not always respond to the fundamental logic's, so be careful not to cast your opinion onto the market via a trading position.

Good Trading

Steve Teunis