ECB Research ECB cutting through the lower bound Danish experiences

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1 Investment Research General Market Conditions 03 November 2015 ECB Research ECB cutting through the lower bound Danish experiences Given the turnaround in the ECB s view on deposit rate cuts, we expect a 10bp cut together with a strong signal that further deposit cuts are on the table. We believe the ECB will reintroduce its old forward guidance, stating that it expects policy rates to stay at present or lower levels for a long time. The main reason we expect the ECB to deliver a deposit rate cut is the strong signal from Draghi, that this is being considered. He has more or less cornered the hawkish ECB members again and pre-announced additional easing. The deposit rate cut also has some benefits related to the impact on inflation, as it on the margin should be more euro negative compared with changes to the QE programme. We believe a cut, together with an open door for further rate cuts, should give lower nominal yields further out on the curve. We expect real yields to fall even more, as the relatively aggressive easing should support inflation expectations. The ECB is looking at other central banks experiences of negative rates. This is likely to include Danmarks Nationalbank, which was forced to cut the key policy rate to -75bp in February this year to fend off appreciation pressure on the DKK. The Danish policy rate has not been fully passed through to short-term money market rates and banks have exempted household deposit accounts from negative rates, while large corporations in general pay interest on bank deposits. ECB research papers This paper is the second in a series of research papers on the menu of monetary policy instruments the ECB could consider at the December meeting. ECB will surprise the markets again 2 November 2015 ECB cutting through the lower bound Danish experiences 4 November 2015 See also: CBPP3: Update on latest figures and the bigger picture 3 November 2015 Pros and cons of the ECB s policy rates tools Instrumen Change Pros Cons Cut MRO * Keep the interest rate corridor fixed * Lower the costs on the TLTRO loans * No effect on money market rates as deposit rate is the leading rate given the large amount of excess liquidity Rate cut Cut deposit rate Reintroduce old forward guidance (policy rates at present or lower levels) Introduce data-dependent forward guidance (policy rates dependent on inflation or inflation exp.) Source: Eurostat, Danske Bank Markets * Lower nominal and real rates (should support inflation exp.) * Weaken the euro and reduce headwind to inflation * Lower nominal yields further out on the curve * Euro yields will be shielded from Fed rate hike * Stronger signal of willingness to maintain an accommodative monetary policy * Risk of negative rates on private sector lending * Negative rates come with a cost for banks * ECB could be forced to raise rates earlier than signalled by forward guidance * Experiences from other central banks imply this type of forward guidance is less credible as it gets revised Senior Analyst Pernille Bomholdt Henneberg perni@danskebank.com Senior Analyst Jens Nærvig Pedersen jenpe@danskebank.dk Senior Analyst Christin Tuxen tux@danskebank.dk Important disclosures and certifications are contained from page 8 of this report.

2 ECB set to cut through the lower bound on the deposit rate Draghi surprisingly opened the door for a deposit rate cut at the ECB meeting in October and we now expect a 10bp cut at the December meeting. The comment from Draghi that further lowering of the deposit facility rate was indeed discussed was a bit of a turnaround, as he had clearly stated now we are at the lower bound, where technical adjustments are not going to be possible any longer at the ECB meeting in September 2014, when the ECB cut the deposit rate last time. According to Draghi, the U-turn should be seen in light of lower inflation expectations, which imply higher real rates when nominal yields are at the zero lower bound. Added to this, he also focused on the stronger euro, the lower oil price and weaker global growth, all of which add downside risk to the inflation outlook. Based on the changed conditions he concluded that the ECB was thinking about going further into negative territory. Draghi also said that the ECB is thinking about the experience of other central banks, which have lowered their rates to much more negative levels. This weekend, Draghi continued this argument and said Now we have one more year of experience in this area: we have seen that the money markets adapted in a completely calm and smooth way to the new interest rate that we set a year ago see interview. ECB to deliver another 10bp deposit rate cut in December ECB s U-turn on the lower bound is due to higher real rates Source: ECB, Danske Bank Markets Source: Bloomberg, Danske Bank Markets Our expectation that the ECB will cut the deposit rate by 10bp is in line with the two previous deposit rate cuts, with the first being the cut into negative territory. We see the risk as skewed towards the ECB cutting the deposit rate more aggressively in an attempt to send a strong signal that it is committed to complying with its mandate of maintaining inflation below, but close to 2%. A larger rate cut could also be seen as consistent with the comment that the ECB is looking at the experiences in other countries. Danmarks Nationalbank and the Swiss central banks have now had a period of around six months with a certificate of deposit rate and sight deposit rate of -75bp, while the Riksbanken in Sweden has cut the repo rate to -35bp. Cutting the deposit rate by only 10bp would on the other hand imply the ECB maintains some room for manoeuvre on policy rates. Related to this, we expect the deposit cut to be accompanied by a strengthening of the ECB s forward guidance (see more on forward guidance below) November

3 Cutting the MRO was not discussed at the latest ECB meeting and we expect the ECB to keep it unchanged at the current level of 5bp. Cutting the MRO would not have an impact on market pricing, as the large amount of excess liquidity implies the deposit rate is the leading policy rate. Added to this, the ECB should wish to keep it in positive territory, which is also the experience of Denmark, where the lending rate has remained unchanged at 5bp since January 2015 despite the deposit rate being cut to -75bp. We judge that the arguments for keeping the MRO rate in positive territory are more important than the fact that cutting the MRO would imply a lower cost on TLTRO loans, which are linked to the prevailing MRO. This should also be seen in light of the lesser importance of adding more TLTRO liquidity since the ECB announced a largescale QE programme. Boosted excess liquidity implies deposit rate is key policy rate A deposit rate cut will give lower nominal short-term yields 80 Eonia - depo (bp) Excess liquidity Eonia RMP - deposit rate Source: Bloomberg, ECB, Danske Bank Markets Low at last liquidity boost Feb13 RMP: 6.3bp Excess liquidity, EURbn Eonia realised over ECB reserve maintenance period (RMP) over deposit rate and exess liquidity bp Jan-14 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Eonia MRO Deposit ECB Eonia fwd Source: Danske Bank Markets Reintroducing forward guidance on policy rates Together with a deposit rate cut, we expect the ECB to signal that rates could still go even lower as has been seen in other countries. Specifically, we expect the ECB to reintroduce its old forward guidance on policy rates, stating that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. In our view, this would be likely to lead the market to price in some probability of further deposit rate cuts immediately after the ECB delivers a cut at the December meeting. Currently, ECB-dated Eonia swaps are being priced close to -30bp, which implies more than one deposit rate cuts would be required for this to be realised. In December, a 7bp deposit rate cut is currently priced. Market pricing implies more than one deposit cut Forward guidance could also shield euro yields from Fed hike 0.40% Pricing EUR-OIS 1m swap 0.30% 0.20% 0.10% 0.00% -0.10% -0.20% -0.30% -0.40% Oct15 Apr16 Oct16 Apr17 Oct17 Apr18 Oct18 Apr19 03-Nov Oct-15 (before ECB meeting) Source: Bloomberg, Danske Bank Markets Source: Bloomberg Danske Bank Markets 3 03 November

4 The market already priced in a deposit rate cut with a probability of around 50% ahead of the dovish stance at the October meeting, and Draghi s confirmation that the ECB is discussing further deposit rate cuts, together with his comments about experiences in other countries, implied swap yields declined further. Currently the EONIA market is pricing in around 14bp in additional cuts over the next year. If the ECB cuts in December, we believe some probability of an additional cut should be priced in, as the ECB wants to keep the door open for further easing if needed. Related to this, the benefit of reintroducing the forward guidance on policy rates would be lower nominal yields longer out on the curve. A strong signal from the ECB that it will keep rates at very low levels for an extended period of time would be a way to strengthen monetary accommodation, as it could result in lower nominal yields extended out to the 5Y segment. Hence, this would be a way to fight the higher real rates due to lower inflation expectations when nominal yields are at the lower bound. Stronger forward guidance could also shield euro area bond yields from an expected Fed hike at the beginning of next year. Although it is not our main scenario, the ECB might consider an even stronger forward guidance and make it data dependent, as other central banks have previously done. An argument against data dependent forward guidance is that the experience of both the Fed and Bank of England is that the guidance is less credible as it gets revised when more data is received. Based on this, we expect the ECB initially to attempt to obtain the benefit of the forward guidance without making it data dependent, although we do not rule out it being forced to introduce stronger, data dependent forward guidance in the future. We see it as likely the ECB will make its forward guidance time dependent. It could do this by stating that the ECB will keep rates at current or lower levels as long as the QE programme is running. Based on our expectation that the ECB will extend QE purchases by three months, this would imply rates should stay at least at the present level until December Such forward guidance would indirectly be data dependent, as the ECB will continue its QE purchases until it sees a sustainable adjustment in the inflation path. Overall, we do not expect the ECB to announce a new lower bound on policy rates. Even if the ECB on the back of the experiences in other countries concludes with a new much lower bound for the deposit rate, we do not believe it will commit to not cutting the rate below a certain level. Instead, by strengthening its forward guidance, some probability of an additional cut should be priced in and the ECB should be able to anchor the longer term of the yield curve. Forward guidance on policy rates could depend on inflation Guidance could also be linked to inflation expectations Source: Eurostat, ECB, Danske Bank Markets Source: ECB, Bloomberg, Danske Bank Markets 4 03 November

5 Another deposit rate cut should weaken the effective euro The main reason behind our call for the ECB to cut the deposit rate below the previously announced lower bound is Draghi s U-turn mentioned above. Once again, he has more or less cornered the hawkish ECB members and preannounced additional easing. Added to this, we base our view on the ECB s focus on higher real rates and the strengthening of the effective euro. In light of this, we see three main reasons why the ECB will end up cutting the deposit rate again. 1. We expect the policy rate instruments on the margin to be more euro negative compared with changes to the QE programme. This said, an expansion of the monthly QE purchases to EUR75bn could be a bit of a surprise for the markets but extending the QE programme beyond September 2016 should not have a strong impact on the effective euro, as the extension is already expected. 2. A lowering of the deposit rate together with stronger forward guidance on policy rates, would put downward pressure on nominal yields. While a rate cut would have a direct impact on short-term yields, a strong signal from the ECB that it is open to cutting rates further would put downward pressure on yields out to the 5Y segment and hence strengthen the monetary accommodation. 3. Real yields should fall even more due to higher inflation expectations if the ECB cuts the deposit rate again. Cutting through the lower bound would be likely to be considered relatively aggressive, suggesting market participants should have more faith in the ECB being willing to do whatever it takes to push inflation back towards the 2% target, thereby putting upward pressure on inflation expectations. The stronger effective euro concerns the ECB The US dollar is not the main driver of the effective euro Source: Eurostat, Markit PMI, Danske Bank Markets Source: Eurostat, Danske Bank Markets In terms of the impact on EUR/USD, we believe the ECB will be satisfied to see it stop strengthening, rather than force about a drop towards, say, parity. While the USD is important for the effective euro, the CNY has a higher weight, hence in terms of the impact on inflation, the CNY should be followed more closely than the USD. We do not expect the ECB to force the EUR/USD significantly lower by cutting the deposit rate beyond what is already priced (some -14bp the next year). We continue to see the cross stay above the March lows, albeit with the possibility of an undershoot of our 3M forecast of 1.08 as the market may price in some likelihood of further ECB cuts and as the Fed delivers the first rate hike. We doubt the ECB settling on -30bp for the deposit rate and a stronger forward guidance will continue to send EUR/USD much lower beyond Q1: with the ECB then set to await the economic impact of past easing and US money markets having adjusted to a shallow hiking cycle from the Fed, the downside from relative rates is set to wane, and EUR supportive factors should gradually take over November

6 The Danish experiences it may not be straightforward Denmark has had a key policy rate of -75bp since February this year, when Danmarks Nationalbank was forced to cut its key policy rate to fend off strong appreciation pressure on the DKK Denmark has a pegged exchange rate vis-á-vis the EUR. In Denmark, the rate of minus 75bp is charged on one week s certificates of deposit, while banks overnight deposits at Danmarks Nationalbank pay 0bp in interest and one week repo loans are charged at a 5bp interest rate. In Denmark, the -75bp key policy rate has not been fully passed through to shortterm money market rates. This is because to some extent Danmarks Nationalbank has eased the pressure on banks from negative interest rates by allowing them to place excess liquidity at 0bp overnight, albeit up to a certain limit. Consequently, banks have exempted household deposit accounts from negative rates, while large corporations in general have earned negative interest on bank deposits. Hence, the Danish experience suggests it may not be straightforward to pass on fully a negative policy rate to market rates. Conversely, this lag of full pass through also means so far there has not been any evidence of an increase in demand for cash. However, we have seen some signs that a negative interest rate on deposits has created an incentive to pay taxes, for example VAT, before the deadline, thus passing on the cost of a negative interest rate to the government the government has been charged a 75bp interest rate on deposits in excess DKK100bn (see FX Strategy: Negative rates obscure Danish tax payments, 21 October). ECB deposit rate is much higher than the Danish equivalent Key policy rate has not been fully passed on to T/N fixing Source: Eurostat, Markit PMI, Danske Bank Markets Source: Macrobond Financial, Danske Bank Markets While Danmarks Nationalbank claims it has not found the lower bound on policy rates and, therefore, policy rates could move lower, we believe Danmarks Nationalbank probably stopped cutting its key policy rate when it reached the global low point set by the Swiss National Bank a couple of weeks earlier. However, the DKK market factored in a further cut immediately following Danmarks Nationalbank s cut to -75bp, which suggests the market at least did not view -75bp as the lower bound. Finally, it is important to note that moving the key policy rate all the way to 75bp did not constrain monetary policy in Denmark. The negative interest policy was employed in combination with Danmarks Nationalbank s version of quantitative easing, which is the purchase of FX. Danmarks Nationalbank purchased FX of DKK275bn, or roughly 15% of GDP, in January and February and committed to an unlimited increase in the FX reserve to avoid a fall in EUR/DKK November

7 In February, market priced in lower key policy rate DKK excess liquidity rose sharply due to FX intervention -0.30% Pricing DKK-OIS 3m swap -0.40% -0.50% -0.60% -0.70% -0.80% -0.90% Feb15 Aug15 Feb16 Aug16 Feb17 11-Feb-15 Source: Macrobond Financial, Danske Bank Markets Source: Eurostat, Danske Bank Markets 7 03 November

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