Negative rates throughout the 2020s?

The result of the latest periodic survey of the European Central Bank (ECB) on economic forecasts (carried out in the last quarter), shows only slight variations with respect to the estimates of the previous quarter, with some adjustments for 2020, 2021 and 2022, but with the long-term expectations (2025) in very similar terms. It estimates one tenth more inflation 1.7% vs. 1.6% than the previous forecast, and one tenth less unemployment 7.6% vs. 7.7% Meanwhile, the forecast for annual GDP growth remains at 1.4%.

If we carry out the simple exercise of comparison with the forecasts made in the last quarter of 2018, in which the devastating effects of Covid-19 on the economy had not yet occurred, the long-term expectations were not radically different. The expected unemployment rate was 7.5%, GDP growth 1.6% and an inflation rate of 1.9%.

Where do we intend to get with this comparison?

The first thing to bear in mind is that, at the end of 2018, interest rates were trading at negative values up to the 5-year term, having a long-term inflation forecast from the ECB very close to its monetary policy objective. Additionally, GDP growth expectations were higher and the expected unemployment rate lower. Finally, it must be considered that the long-term forecasts in 2018 were for 2023, which means that the objectives were intended to be achieved long before the values shown in the last survey, which, we should remember, are for 2025.

That is, by making a simple association of ideas, we can infer that negative interest rates will be with us for much longer, at least until 2025, since the inflation data would still be outside the tolerance margin with respect to the central objective of 2% and with a modest GDP growth figure.

On the other hand, in its latest pronunciation on monetary policy, the ECB makes it clear that, in view of the latest macroeconomic data and estimates, it will continue to apply the necessary measures to boost economic recovery and counteract the negative impact of the pandemic. This, of course, without forgetting its main objective, which is to control the path of the CPI, but with the nuance that it will seek a balance between the evolution of both indicators.

In other words, we can infer that negative interest rates will be maintained in the deposit facility and that the ECB will keep them that way until inflation is close to the target (although they admit that it will be less than 2%). It will also maintain, and increase, the rest of the stimulus programs, such as the massive purchase of assets (PEPP and APP) and the long-term refinancing program (TLTRO III).

Going back to the simple association of ideas, and based on all this information, it could be deduced that there are high probabilities of living with a negative rate scenario until at least 2025.

What additional information can we get from the market?

The IRS curve is currently in negative values until the term of 15 years (remember that in 2018 the negative values reached until the term of 5 years only).

The discouraging conclusion for the traditional banking business is that, due to the consequences derived from the current economic crisis, such as the low demand for credit and the foreseeable increase in non-performing loans (it is estimated, in this sense, that a good part of the moratoriums granted will end in defaults) and unemployment, adds a scenario of negative interest rates that could be extended until 2028 (AFI, current situation report Nov-20) and others even until 2031.

What is clear is that these are bad times for banks in Europe and, especially, in Spain. In fact, 7 of the 8 entities in the country that are listed on the stock market, that is, all the large banks except one, have recently reached their historical lows and some of them could even end the year with negative returns, despite the latest concentration movements in the sector.

What are the consequences for the Banking Industry?

Thus, the return on capital or ROE achieved by Spanish banks this year could be reduced by 400 basis points compared to the 6.1% average of 2019 according to some publications.

The average profitability forecast for 2020 of banks in Spain stands at 2.2%, being the third lowest in Europe after the -0.5% estimated to be reached by German banks and 1.2% by British entities. Meanwhile, French banks will stand at an average of 2.6%, those of Italy 2.9% and those of Denmark 3.7%, far from the 10.4% of Swiss banks (the highest in Europe).

Looking ahead to 2021, estimates predict an improvement in the ROE forecasts in the main European countries, except in the case of Switzerland, which will fall to 10.1%. However, the average ROE of Spanish banks would amount to 3.2%, the second lowest in Europe after 0.9% in Germany.

In fact, the ECB has published a report at the end of November highlighting the increase in the bank’s vulnerability in the euro zone in the medium term, due, among other factors, to the fact that their profitability will remain low for a long time. This, for the ECB, is a risk for the financial stability of the eurozone.

In the case of Spain, and addressing the problem on the value side, only in the last year the eight listed banks have lost about 52.3 billion euros of market capitalization, which implies that they have lost 40% of their stock exchange value compared to twelve months ago, when at least the smallest ones were already trading at prices well below their book value. Today the discount applied to entities in the market has reached historical highs above the other two most recent major economic crises, the 2008-2009 and the 2012, due to the risk of debt default in southern Europe.

In an environment like the current one with such an acid and prolonged expected scenario, the ALM function is of vital importance, having to provide the necessary analysis and management tools to optimize the bank’s expected results for the coming years.

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