Investment Research General Market Conditions 3 December Dec HICP (flash est. 0.1%) LTRO1 matures

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1 Investment Research General Market Conditions 3 December 214 ECB preview ECB s timeline is tricky isn t it? The ECB has eased twice in 214, but liquidity conditions in the Euro system will still be balancing around critical levels in Q1 next year. This follows as the TLTRO operations do not have the size or timing to match the reduction in excess liquidity due to the repayments of the two 3Y LTROs. After the fall in liquidity, the take on the weekly MRO auction is likely to increase, as it will work as a buffer. But this is usually not a forward looking process and it is likely to follow after liquidity has fallen. Hence, there should be a short-term fall in liquidity and upward pressure on short-end money market rates. The ECB is still expecting the current measures to be sufficient in boosting the balance sheet to 212 Q1 levels, but in mid-december, we expect the ECB will start to realise more is needed to reach the EUR3tr soft target, as the TLTRO allotment in December should be a disappointment. We expect the balance sheet will remain far from the soft target of EUR3tr and without a broadening of the ECB purchases the balance sheet is expected to be broadly at the same level in mid-march 15 as it was in September 14, when Mario Draghi first introduced the soft balance sheet target. We expect the ECB to expand its purchases to corporate bonds in January followed by sovereign bonds in Q2. Government bond purchases will most likely be conducted according to the ECB s capital key and Portugal is set to be the biggest beneficiary due to a relative high capital key and a low amount of PGBs. ECB previews Dovish ECB waits for the December TLTRO 2 December ECB s timeline is tricky isn t it? 3 December ECB meeting 4 December Senior Analyst Pernille Bomholdt Nielsen perni@danskebank.dk Senior Analyst Anders Møller Lumholtz andjrg@danskebank.dk Analyst Anders Vestergård Fischer afis@danskebank.dk ECB s Q1 timeline is tricky isn t it? Year end Balance sheet ~EUR2.1bn End Q1 Balance sheet ~EUR2.1tr (after March TLTRO) ECB waiting for impact of the easing measures ECB starting to realise more easing could be needed ECB to grab for more tools in the toolbox 4 Dec 11 Dec 12 Dec 17 Dec 19 Dec 7 Jan 22 Jan 29 Jan 3 Jan 26 Feb 2 Mar 5 Mar Mar Q2 TLTRO2 allotment LTRO announcement TLTRO2 settlement Last LTRO repayment in 214 announced Dec HICP (flash est..1%) LTRO1 matures Jan HICP (flash est..2%) LTRO2 matures Feb HICP (flash est..1%) TLTRO3 allotment+ settlement ECB meeting (new forecasts) ECB likely to be disappointed > starting to realise more is needed ECB meeting Disappointing take on Dec TLTRO > corporate bond purchases announced ECB meeting (new forecasts) Balance sheet target not reached in Q2 > QE in government bonds announced ECB waits for the December TLTRO Draghi is as dovish as he can be Could make something short-term to limited the drop in liquidity ECB waits for the March TLTRO Still very dovish as inflation is low Important disclosures and certifications are contained from page 8 of this report.

2 Events affecting the development in liquidity in Q1 Although the ECB has eased twice in 214, liquidity conditions in the Euro system will still be balancing close to critical levels in Q1 next year while the balance sheet will be far from the EUR3tr soft target. In fact, without a broadening of the ECB purchases the balance sheet is expected to be broadly at the same level in mid-march 215 as it was in September, when Mario Draghi first introduced the soft balance sheet target. In terms of liquidity the run-off of the two 3Y LTROs (currently EUR277bn outstanding) will in isolation reduce excess liquidity, and the TLTRO operations do not have the size or the timing to match this run-off. Even though we expect the weekly MRO to increase and effectively prevent any liquidity squeeze, the next couple of months have several events which have the potential to change the short-term outlook. Below we provide an overview: The ECB expects the current measures are enough Excess liquidity to decline and put upward pressure on rates 25 2 Excess liquidity (EUR bn) dec-14 mar-15 jun-15 MRO as buffer Excess liquidity (unchanged MRO and aut. factors) 4 December: ECB meeting The upcoming December ECB meeting will get a lot of attention, as a number of ECB members have expressed very dovish views, which have implied the market is pricing in further easing measures. Nevertheless, we believe that the ECB will keep the powder dry in December as it waits for the take-up on the TLTRO in mid-december, but at the same time that Draghi will sound as dovish as he can without actually easing. Our expectation follows as the ECB still believes the current easing measures are enough to boost the balance sheet and that the medium-term outlook for inflation expectations has not worsened enough to warrant more easing, see more in ECB preview: Dovish ECB waits for the December TLTRO take-up. Currently, the consensus within the Governing Council is that it is waiting for the impact on the balance sheet and economy of easing measures that have already been announced. 11 December: December TLTRO allotment The TLTRO allotment in December is, in our view, expected to be a disappointment for the ECB. Hence, in mid-december the ECB is likely to start to realise more easing is needed in order to reach the soft balance sheet target of EUR3tr. The main reason for the ECB to revise its current view, that the announced measures will have a sizeable impact on the balance sheet, is that the TLTRO is the operation with the largest potential to boost the balance sheet. Furthermore, Draghi has said the ECB may make a more precise estimate of the impact on the balance sheet once the first two TLTROs have taken place. 2 3 December 214

3 Current measures will not be enough to reach the target Negative impact on balance sheet from earlier programmes Considering the other unconventional measures, we expect the CBPP3 will increase the balance sheet by around EUR15bn, while we expect the ABSPP could increase the balance sheet by up to EUR1bn. Thus, a very large take-up on the future TLTROs is needed in order to reach the ECB s target of expanding the balance sheet by EUR1tr from the current level. We expect banks will take EUR12bn on the December TLTRO, implying the total take-up will be around EUR2bn out of EUR4bn eligible on the first two TLTROs, where the eligible amount is dependent on the loan stock. The ECB is probably expecting a take-up of at least EUR15bn and probably hoping for EUR2bn or more. Shortly after the TLTRO was announced, Draghi said that it had the potential to increase the balance sheet with a maximum of EUR1tr, and when he mentioned a lower number a month later, he was referring to market estimates of the take on the TLTROs and not the forecast from the ECB. Our forecast for a higher take-up on the December TLTRO compared to the first in September follows, as banks should demand more liquidity after the ECB s Asset Quality Review and Stress tests showed very limited capital shortfalls. Added to this some banks are expected to use the opportunity to bridge the 3Y LTROs, which mature in Q1 15. In spite of this, when we aggregate our forecasts across countries we end up with an estimate which is below the Bloomberg consensus of EUR17bn. This probably reflects that we expect an aggregate take-up from German banks of around EUR2bn on both the September and December TLTRO, which is low compared to an eligible amount of EUR95bn. We expect a take-up of EUR12bn on the December TLTRO The TLTRO has the largest potential to boost the balance EUR bn just above 2Bn in first two operations EUR bn EURbn jul 14 okt 14 jan 15 apr 15 jul 15 okt 15 jan 16 apr 16 Danske expectations (lhs) TLTRO acc. take-up (rhs) Current bal. Sheet SMP CBPP1 CBPP2 LTRO After deductions TLTRO (remaining) CBPP3 ABSPP Needed Target 3 3 December 214

4 12 December: LTRO announcement The net impact on excess liquidity from the December TLTRO will be known on 12 December when the weekly repayment of the 3Y LTROs is announced. In terms of impact on money market rates it is the net effect from both 3Y LTRO repayment and the TLTRO allotment that matters as they both settle on 17 December and as some of the take-up on the TLTRO will be a roll-over of the current LTROs. In case there is a net positive impact on liquidity this will be supportive for lower EONIA fixings at end- December. 19 December: Last LTRO repayment in 214 announced There is a potential decline in excess liquidity on 19 December as there is a risk that some banks will repay the remaining liquidity on the LTROs before year-end (currently EUR277bn outstanding). Although the ECB has cancelled the last repayment possibilities in 214, we could see elevated repayments as we did in 213. This would give upward pressure on EONIA fixings and if we are right, and the ECB does not ease further in December, the ECB will have to wait until the meeting on 22 January before it can add more liquidity to the system. However, we believe the weekly MRO auction will work as a buffer (see more below). Net positive impact on liquidity supportive for lower EONIA Could see elevated LTRO repayments around year-end EURbn LTRO 1 & 2 jan-13 feb-13 mar-13 apr-13 maj-13 jun-13 jul-13 aug-13 sep-13 okt-13 nov-13 dec-13 jan-14 feb-14 mar-14 apr-14 maj-14 jun-14 jul-14 aug-14 sep-14 okt-14 nov-14 Monthly Repayment Outstanding 22 January: ECB meeting We expect the ECB to broaden its asset purchase programme to include corporate bonds at the meeting in January. This should follow as we expect the ECB has realised more is needed to reach the balance sheet target after the expected demand for liquidity on the December TLTRO was weaker than the ECB expected. Additionally, the pressure on the ECB is likely to have increased further in January as we expect inflation to decline to.1% in December, which is a new post-crisis low see Flash Comment - We expect euro inflation to decline to.1% in December. Furthermore, the early repayment of 3Y LTRO could give upward pressure on short-end money market rates and give the ECB more headaches. Although Draghi has said the current purchase programme could be extended to include sovereign bonds, we believe the ECB will start by expanding purchases to corporate bonds. This should follow as Draghi seems to prefer purchases close to the credit channel while there is still opposition against government bond purchases from members in the Governing Council. Here, the German camp is not alone in its reluctance towards an aggressive QE programme, but also board member Yves Mersch has argued there can be unintended side effects if unconventional monetary policy is used too aggressively. 4 3 December 214

5 An announcement of corporate bond purchases will not affect liquidity immediately, hence the market impact will mostly be through signalling that the ECB is willing to broaden its programmes as the purchases will only come gradually as we have seen with the CBPP3 purchases. In case the ECB wants to limit the drop in liquidity it could decide to reduce the minimum reserve requirements, which would free up to EUR1bn in liquidity, but this is not our main scenario. Corporate bond purchases to increase balance a little Gradual impact on liquidity from CBPP purchases EURbn Current bal. Sheet SMP CBPP1 CBPP2 LTRO After deductions TLTRO (remaining) CBPP3 ABSPP Corporate bonds (SSA) Needed Target 29 January and 26 February: LTRO1&2 mature The two 3Y LTROs mature ultimo January and February and any liquidity, which has not been repaid, will be repaid, hence excess liquidity will be reduced in end-q1. There is currently EUR88bn outstanding on the LTRO1 and EUR188bn on the LTRO2. Following the fall in liquidity after the repayments, the take on the weekly MRO auction is likely to increase as it will work as a buffer. But this is usually not a forward looking process and the take on the MRO is likely to follow after liquidity has fallen. Hence, there will still be a fall in liquidity and upward pressure on short-end money market rates. The size of the balance sheet should also decline due to the 3Y LTRO repayments and at the beginning of March we expect the balance sheet to be close to the level it had in September 214, when Draghi mentioned the soft balance sheet target the first time. This forecast is even based on an additional take on the weekly MRO auction during March. TLTRO will not be large enough to cover run-off of the LTROs MRO will work as a buffer, but liquidity will fall short-term EURbn Excess liquidity (EUR bn) LTRO 1 (Dec-11) LTRO 2 (Feb-12) LTRO 1 & 2 Total amount LTRO 1 & 2 Total repayment LTRO 1 & 2 Outstanding TLTRO 2 DB Estimate MRO acts as buffer dec-14 mar-15 jun-15 MRO as buffer Excess liquidity (unchanged MRO and aut. factors) 5 3 December 214

6 5 March: ECB meeting If we are right and the ECB eases in January, we expect it to remain on hold at the March meeting. Like in December, the ECB will be waiting for the next take-up on the TLTRO in March, which will be the first, where the take-up is depending on the development in net lending and not the loan stock. Moreover, the ECB is likely to publish new projection in March, where a continued decline in the oil price will have a negative impact on the forecast. The risk at the meeting is tilted towards ECB hinting at government bond purchases. Q2: ECB to buy government bonds Corporate bond purchases from the ECB should not be enough to increase the balance sheet to EUR3tr (see the chart on the previous page) and in H1 15 the pressure on the ECB to ease again is set to remain, as we expect the balance sheet will only increase gradually, while we forecast inflation will remain very low around.2% in H1. Hence, the ECB should expand its purchases further to also include government bonds in Q2. Mario Draghi has until recently focused on monetary easing aimed at improving credit growth, but in a speech held in November, he talked about how asset purchases, in general, affect the economy. First, he described how rising asset prices also supports bank lending as it frees up capital resources for additional lending. Added to this, he mentioned that purchases would give a currency depreciation and that it would have a strong signalling effect, which would help anchor inflation expectations and thereby lower real interest rates. This shift in focus, in our view, strengthens the case for the ECB to buy government bonds, although it remains unclear how strong the support is within the Governing Council. This opposition implies we expect the scale of the purchases to be smaller than the market is hoping for. The expansion to government bond purchases should come even though growth gradually recovers, see The Big Picture: Synchronous global recovery in H1 15- This should follow as the primary objective of the ECB is to achieve price stability and we forecast inflation will remain very low while the balance sheet will not increase sufficiently. Government bond purchase to give a currency depreciation and help anchor inflation expectations Source; ECB, Danske Bank Markets 6 3 December 214

7 Impact of government bond purchases The government bond purchases will most likely be conducted according to the ECB s capital key as hinted by Constancio recently. Furthermore, it is likely that the ECB will require that the sovereign has fully restored market access and maybe even exited EU/IMF programmes. Hence, Greece is likely initially to be excluded from ECB s purchases. Greece would otherwise have been the biggest beneficiary due to the low amount of free floating bonds. We do think that both Ireland and Portugal would be included. Portugal is thus set to be the biggest beneficiary due to a relatively high capital key and low amount of PGBs. A large fraction of Portugal s public debt is in other instruments including the EU/IMF loan facilities. Also, German bonds should get a boost from the ECB purchases. Spain is set to benefit more than Italy on a relative basis. ECB s capital key Portugal set to be biggest beneficiary from ECB QE in govies 3% 25% 2% 15% 1% 5% % 26% 2% 18% 13% 6% 4% 3% 3% 2% 3% 2% 2% DE FR IT ES NL BE GR AU PT FI IE Others Buying according to ECB capital key Bying according to GDP weight ECB QE - Share of outstanding government bonds 5 % GR PT DE FI ES Nl FR AU IE IT BE EUR 1,bn programme EUR 5bn programme Source: Danske Bank Markets 7 3 December 214

8 Disclosure This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The authors of the research report are Pernille Bomholdt Nielsen, Senior Analyst, Anders Møller Lumholtz, Senior Analyst and Anders Vestergård Fischer, Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. 8 3 December 214

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