Negative interest rates in Japan and Europe have played a major role in market volatility this year, hitting banks’ profitability and signaling central bank failure to spark inflation to prescribed targets. Falling commodity prices have added to concerns over deflation.
“Strikingly, the slide on stock markets steepened exactly when interest rates were pushed noticeably into negative territory,” Donay wrote in a recent research note.
However, investor fears are contradicted by economic fundamentals, which he said “have shown little sign of turning for the worse”.
Therefore, Donay believes if at least one of three broad shifts start to occur, it would encourage a more balanced view of economic fundamentals and trigger a sustainable rally:
- Oil prices stabilising around $45-$50 per barrel, which should promote inflation and ease default risks for energy companies. “But daily production needs to fall by around 1.5 million barrels to rebalance supply and demand, which will take several months,” Donay said.
- The second concerns negative interest rates. Developed-economy central banks would need to reverse monetary policy, which would include bringing European Central Bank and Bank of Japan short-term interest rates back into positive territory. But he calls this unlikely in the near term.
- International cooperation to drive “a strong new policy mix, including a fiscal component, to dispel deflationary pressures in the developed world”. However, he pointed out that no major initiatives resulted from the recent G-20 meeting last month.
“In the absence of these fundamental changes, rebounds on equity markets are still possible — such as over the past week — but are likely to prove weak and short-lived,” Donay wrote.
The ECB’s monetary policy meeting on March 10th will be closely watched as authorities could push interest rates down further into negative territory, to -0.5% by June, he believes.
“Nevertheless, other [ECB] measures such as extension of its asset purchases, for instance to corporate bonds, could help to reassure markets, at least temporarily.”