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Why European Banks Could Be About to Get Hammered Again

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The Euro Stoxx Bank Index is not a widely followed gauge on Wall Street, but it is arguably becoming ever more important the deeper Europe moves into negative interest rate territory. A close proxy of it available for U.S. investors is the iShares MSCI Europe Financials ETF (NASDAQ:EUFN). The index consists of 26 leading European banks and serves as a gauge of the health of the European financial system. It is not doing particularly well, and could soon break through all time lows, for several reasons.

on Thursday, European Central Bank President Mario Draghi will oversee his final meeting as head of the ECB. He is widely expected to push the euro zone even deeper into negative interest rate territory in a bid to strengthen the macroeconomic picture and keep the euro zone out of recession. Draghi's successor, former International Monetary Fund head Christine Lagarde, is on record advocating even deeper negative rates into the future.

The problem is, while pushing rates deeper into negative territory could theoretically encourage spending and somewhat improve economic data readouts, it could also damage the already weak European banking system. German lenders have publicly warned the ECB that any further easing into negative territory would not help them. On the contrary, it would hurt by making it even harder for banks to make money on loans. Commerzbank (OTCPK:CRZBY) CEO Martin Zielke for example was somewhat blunt, saying that such policy was neither sustainable nor responsible, and could risk serious side effects.

Zielke did not specify side effects, but it is possible to speculate logically. Since banks are forced to shoulder the costs of holding deposits in a negative rate environment, negative rates become a slow and enervating bloodletting for banks. It is probably no coincidence that the Euro Stoxx Bank Index is trading perilously close to all-time lows. See this chart from MarketWatch below.

Euro Stoxx Bank Index
Euro Stoxx Bank Index

The coincidence of low bank equity prices and negative interest rates is especially concerning given that banks are some of the biggest holders of euro zone sovereign bonds, almost all of which are trading at all-time highs. They are certainly trading at vastly higher levels than back in 2012, when interest rates on sovereign bonds reached worrying levels as Greece was on the brink of default. Italy's 10-year yield, for example, was at one point during the peak of the Greek debt crisis upwards of 7.5%. Since then, Commerzbank shares have fallen by a dizzying 70%. Clearly, lower interest rates have not helped European bank stocks one bit, at least not so far.

This is actually a bit puzzling to mainstream economists because high bond prices should theoretically pad the balance sheets of these banks. Higher nominal values for bond portfolios help inflate asset-to-liability ratios, though it seems investors don't care particularly much. Many bank stocks are decidedly lower than when euro zone sovereign bonds looked to be on the brink of default, so it clearly is not working at all.

What other side effects could materialize if Draghi and his successor Lagarde continue down the path of deeper and deeper negative interest rates? Well, for one it could lead to a higher U.S. dollar index as European banks look to escape negative euro rates, offering higher sums to convert euros into dollars and earn positive nominal rates from the Federal Reserve. That would give the Fed more room to ease for its part, something that is widely expected at its own Federal Open Market Committee meeting next week.

It is important to keep in mind that in the background of all this is a new Italian Prime Minister bent on loosening European Union budget deficit rules. Prime Minister Guiseppe Conte is now calling for reform of EU budget deficit limits, which are currently set at 3% of GDP, but Conte wants the ability to go into debt even more. Italy has already been warned against this type of move by the head of euro zone finance ministers, Mario Centeno. If Brussels sticks firm, automatic tax increases that go into effect in Italy by next year, it is feared they could plunge the country deeper into recession, where it has been technically since the beginning of 2019.

These factors, and Brexit at the doorstep, makes it look as though 2020 is going to be a rough year for European banks, and the euro itself. The Euro Stoxx Banks Index could shortly break through its triple bottom and head to new all-time lows.

Disclosure: No positions.

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This article first appeared on GuruFocus.