ECB s easing package and markets zig-zag

ECB s easing package and markets zig-zag Pernille Bomholdt Henneberg Jens Peter Sørensen Christin Tuxen Senior Analyst, Euro Macro Research Chief Analyst, Fixed Income Research Senior Analyst, FX Research perni@danskebank.com jenssr@danskebank.dk tux@danskebank.dk +45 30 51 53 75 +45 45 12 85 17 +45 45 13 78 67 11 March 2016 Investment Research Important disclosures and certifications are contained from page 19 of this document

ECB announced a large easing package markets zig-zag The ECB has again announced a large package of easing measures including: A cut in the deposit rate of 10bp to -0.40%, a 5bp cut in the MRO rate and the marginal lending facility to 0.00% and 0.25%, respectively. The forward guidance on policy rates was maintained (present or lower levels) and was strengthened slightly by making it time dependent (for an extended period of time, and well past the horizon of our net asset purchases). An increase in the monthly QE purchases to EUR80bn from EUR60bn starting in April 2016 intended to run until the end of March 2017, or beyond, if necessary. The issuer and issue share limits for the purchases of securities issued by eligible international organisations and multilateral development banks was increased from 33% to 50%. An expansion of the eligible assets in the QE programme to include investment grade euro-denominated bonds issued by non-bank corporations established in the euro area starting towards the end of Q2 16. A new series of four TLTRO II, starting in June 2016, with a maturity of four years. The interest rate will be fixed over the life of each operation at the MRO rate prevailing at the time of take-up. For banks whose net lending exceeds a benchmark, the rate will be lower, and can be as low as the deposit rate prevailing at the time of take-up. The initial announcement was a big positive surprise, which clearly supported risk sentiment across assets. Usually, the ECB announces the rate decision at 13:45 CET, while other measures are communicated at the press conference starting 14:30 CET, but today, all measures were announced at 13:45 CET, which was a big surprise supporting the positive sentiment. Nevertheless, at the end of the day bond yields were higher, EUR/USD surged and euro stocks were lower. The reversal in risk sentiment followed during the Q&A when Draghi said that he does not anticipate more rate cuts based on the current view. 2

ECB s focus is shifting from currency to bank-lending channel The monetary policy announcement shows that the ECB's focus is shifting from the interest, currency channel to the bank-lending, credit-channel. In our view, this is an important move, as the bank lending channel plays a crucial role in the transmission of the monetary policy in the euro area where bank lending intermediated around 80% of credit flows. Based on this, we expect the announced easing measures will support the recovery. Including corporate bonds in the QE universe will reduce the systemic risks. Ahead of the ECB meeting we had argued that a circuit breaker for euro credit could be for the ECB to buy credit bonds, as this was one of the markets most under pressure during the risk-off sentiment in January-February. We believe the comprehensive easing package has bought the ECB some time before additional easing will be required. Over the coming three-six months focus will be on the details and impact of the easing measures and, in our view, the ECB will remain on hold during that period. In a longer-term perspective, it is still likely that the ECB will extend the QE purchases beyond March 2017, as inflation has not picked-up sufficiently. In the ECB s updated inflation projection, it expects inflation to increase to only 1.1% in Q1 17, while it is still too optimistic on its outlook for core inflation (it expects core inflation of 1.1% on average in 2016, up from 0.7% in the latest flash estimate from February 2016). Added to this, we expect the ECB and Europe will over time get a stronger effective exchange rate due to fundamental factors. This would be negative for core inflation in the euro area and hence continue to challenge the effectiveness of the announced measures. 3

ECB announced a large easing package Small deposit rate cut Easy to get consensus about Strengthen forward guidance Lift inflation target Change conditions on current TLTRO Expand monthly QE purchases Buy corporate bonds (not financials) Weak impact on inflation Buy equities Strong impact on inflation Buy a larger share of linkers Introduce core inflation target Introduce inflation target range New TLTRO (with negative rate) Significant deposit rate cut Fully open-ended QE porgramme Buy non-performing loans FX interventions Guidance Rate cuts QE Liquidity Hard to get consensus about Blue sky thinking Coloured boxes show what the ECB delivered in March 2016 Helicopter money 4

Another rate cut but Draghi sees no need for further cuts The deposit rate cut of 10bp to -0.40% was in line with our and consensus expectations, but a small disappointment in fixed income and FX markets as a deposit rate cut of around 12bp was priced in ahead of the ECB meeting. In terms of additional rate cuts Draghi said during the Q&A session that he does not anticipate more rate cuts. This immediately reversed the positive risk sentiment and the day ended in a risk-off movement. The markets now only price in an accumulated 5bp deposit rate cut this year. In our view, this is a very important signal that the currency war is over, as it suggests that the ECB's focus is shifting from the interest, currency channel to the bank-lending, credit-channel. This is set to support the recovery, as the negative interest rates are not helping the bank lending channel which the euro area economy is so dependent on. The comment from Draghi about no anticipated further rate cuts followed despite the ECB maintaining its forward guidance and strengthening it by making it time-dependent. The ECB did not introduce a two-tier deposit rate system, which would have reduced the cost of the negative deposit rate to the banking sector, and in that way has signalled that the deposit rate could go even lower. The ECB lowered all three key policy rates Source: Bloomberg, ECB, Danske Bank Markets 5

Repricing the short end of the curve due to a new lower bound Repricing of the short-end of the curve as the market adapted to the new lower bound. The repricing weighed on the whole curve and the long-end also suffered 10 bp 5 0-5 The markets now only price in an additional 5bp deposit rate cut this year ahead of the ECB meeting an accumulated 30bp deposit rate cut was priced in 0,0-1,0 bp -0,1-10 -15-2,0-2,0-20 -25-3,0-2,5-30 -35-4,0-3,8-40 -45-5,0 ECB dated Eonia swaps (assuming neutral Eonia is 6bp above deposit rate) -4,7-5,0-50 jan-15 jun-15 dec-15 jun-16 dec-16 jun-17 dec-17 Eonia MRO Deposit ECB Eonia fwd Pre Mar ECB meeting -6,0 apr-16 ECB jun-16 ECB jul-16 ECB sep-16 ECB okt-16 ECB dec-16 ECB -5,6 jan-17 ECB Source: Bloomberg, ECB, Danske Bank Markets Source: Bloomberg, Danske Bank Markets 6

Expanding QE purchases to support inflation The increase in QE purchases of EUR20bn per month to EUR80bn will start from April this year. This is set to boost the total QE programme by EUR240bn based on the current end-date of the QE purchases in March 2017, taking the total size of the QE programme to EUR1,740bn. The increase in the QE programme is, in our view, a strong signal from the ECB that it is willing to fight very low inflation. Draghi has previously said that a worsening of the mediumterm outlook for inflation would require a meaningful increase in the degree of monetary accommodation, which would be in the context of a more broad-based asset purchase programme. The increase in the QE purchases should again result in a hunt for yield and push investors into the periphery. This should follow as a very high share of core and semi-core bonds are yielding below negative. The higher monthly QE purchases could also flatten the German yield curve even more as investors will be forced longer out on the curve. Details about the ECB's QE programme Size of programme Limit on purchases Around EUR1740bn including all eligible assets Purchases will be open-ended ("will in any case be conducted until a sustained adjustment in the path of inflation" ) Start of purchases Purchases initiated in March 2015 Pace of purchases Risk sharing Seniority Distribution Products Maturity Sterilisation EUR80bn p/m including non-financial corporate bonds with an increase of EUR20bn per month in April 2016 20% of potential financial risk will be shared within the Eurosystem Bonds will be pari-passu to other investors Buying according to ECB's capital key IG sovereigns, agencies, regionals, non-financial corporates and linkers (also negative yielding bonds but not below the deposit rate) Range between 2Y and 30Y No sterilisation Conditionality Flexibility No conditionalities Purchases moderately frontloaded in May and June 2015 and scaled up by EUR20bn per month in April 2016 7

QE expansion set to boost liquidity to even higher levels Excess liquidity will increase sharply during 2016 even under a very conservative assumption about the TLTRO (here, a roll over of existing TLTRO is included) The ECB balance sheet will increase significantly above the previous peak in 2012 due to the QE programme 8

More targeted QE purchases by including corporate bonds Including corporate bonds in the QE universe will reduce the systemic risks. Ahead of the ECB meeting we had argued that a circuit breaker for euro credit could be for the ECB to buy credit bonds as this was one of the markets most under pressure during the risk-off sentiment in January-February. According to the minutes from the January 2015 ECB meeting As regards the most appropriate instruments for achieving additional monetary stimulus, the point was made that purchases of corporate bonds could be seen as the most natural extension of the Governing Council s credit easing package, representing a more targeted measure directed towards a further improvement in the financing conditions of firms In terms of size, we estimate that eligible purchases amount to around EUR450bn (EUR denominated, non-financial, IG rated, benchmark size corporate bonds). The announcement is clearly supportive for euro IG space as demand for eligible bonds will increase and this will support their spreads. It should also give some relief further down the credit curve as investors will be crowded out by the ECB and hence search for alternative investments. Eligible purchases of non-financial corporate bonds amount to around EUR450bn 9

Financing conditions of firms are expected to improve Demand for eligible corporate bonds will increase and support their spreads, but it should also give some relief further down the credit curve as investors search for yield Including corporate bonds in the QE universe represents a more targeted measure directed towards a further improvement in the financing conditions of firms Source: Bloomberg, Danske Bank Markets 10

A new TLTRO II aimed at boosting private sector lending The TLTRO II provides very cheap funding (interest rate fixed a zero or negative) for four years not subject to mandatory early repayments. Based on these very attractive long-term funding conditions to banks it is likely that demand from banks will be higher than seen on the first TLTRO. The lending benchmark should not be very difficult to beat, which increases the demand for funding as this implies a number of banks will be able to obtain long-term funding at a negative interest rate. Based on this, the TLTRO II should support the supply side of a further ease in private sector credit conditions. However, the improved credit creation also requires a demand for additional bank lending. In the latest ECB bank lending survey banks reported an increase in demand for loans from enterprises, but increased uncertainty and weaker business sentiment could be negative for investments and hence demand for lending. Another constrain to improved lending conditions is bank regulation. Details about the ECB's TLTRO II Total eligible amount Maturity Repayments Interest rate Conditions for receiving a rate reduction Benchmark (positive eligible net lending) Benchmark (negative eligible net lending) 30% of loans to non-financial corporations and households excluding loans for house purchases as at 31 January 2016 less any outstanding amount under the first TLTRO Four years from settlement date, with the possibility of repayment after two years at a quarterly frequency No mandatory early repayments, but possible after two years from the settlement of each operation on a quarterly frequency Fixed at the MRO rate prevailing at the time of allotment, but by exceeding the lending benchmark the rate can be as low as the deposit rate at the time of allotment Banks exceeding their benchmark stock of eligbile loans by 2.5% in total as at Jan-18 will receive the max rate reduction equal to the difference between the MRO rate and the deposit rate at time of take-up. Up to this size the decrease in the interest rate will be graduated linearly depending on the percentage by which a bank exceeds its benchmark stock of eligible loans. Banks which had positive eligible net lending in the 12m period to January 2016 will have net lending benchmark set at zero Banks which had negative eligible net lending in the 12m period to January 2016 will have net lending benchmark set equal to the eligible net lending in that period Auctions Four operations conducted from June 2016 to March 2017 at a quarterly frequency 11

TLTRO II gives very attractive long-term funding conditions The TLTRO II allowance is high and given the very cheap, long-term funding conditions banks should demand a higher amount of liquidity compared to the first TLTRO MFI loan stock to private sector (Jan-16) TLTRO II allowance (30%) Euro Area 5.643 1.693 Germany 1.356 407 France 1.166 350 Netherlands 435 130 Belgium 138 41 Austria 214 64 Finland 105 32 - Core countries 1.024 Italy 1.057 317 Spain 692 207 Greece 131 39 Portugal 104 31 Ireland 71 21 - Periphery countries 2.054 616 - Other EA countries 176 53 1.385 EUR bn Germany (positive eligible net lending) 1.380 1.375 1.370 1.365 1.360 1.355 1.350 1.345 1.340 1.335 apr-12 okt-12 apr-13 okt-13 apr-14 okt-14 apr-15 okt-15 apr-16 TLTRO eligible lending Benchmark Lending since Jan-15 950 EUR bn Spain (negative eligible net lending) 900 850 800 750 700 650 600 apr-12 okt-12 apr-13 okt-13 apr-14 okt-14 apr-15 okt-15 apr-16 TLTRO eligible lending Benchmark Lending since Jan-15 12

Bank lending has improved but lost some momentum lately Bank lending to the private sector has improved in 2014-15, but has lost some momentum at the end of 2015. The TLTRO II aims at maintaining the progress in bank lending Demand for loans and credits from enterprises is increasing due mainly to financing needs for inventories & working capital as well as for fixed investments 13

ECB lowered its inflation projection significantly ECB lowered its inflation projection for 2016 significantly, but it was mainly due to the oil price decline and the ECB is still too optimistic on its core inflation forecast ECB projections 2015 2016 2017 2018 GDP growth HICP inflation Core inflation Unemployment rate Wage growth 1.5% (1.5%) 0.0% (0.1%) 0.8% (0.9%) 10.9% (11.0%) 1.3% (1.4%) 1.4% (1.7%) 0.1% (1.0%) 1.1% (1.3%) 10.4% (10.5%) 1.5% (1.5%) 1.7% (1.9%) 1.3% (1.6%) 1.4% (1.3%) 10.2% (10.1%) 1.9% (2.1%) 1.8% 1.6% 1.6% 9.9% 2.1% Source: ECB, Eurostat, Danske Bank Markets Source: ECB, Eurosat, Danske Bank Markets 14

ECB is still too optimistic on its core inflation projection The ECB expects core inflation to increase to 1.1% on average in 2016, which requires a considerable increase from the flash print of 0.7% in February Source: ECB, Eurostat, Danske Bank Markets Source: ECB, European Commission, Eurostat, Bank Markets 15

Leaving the currency war will give headwind to core inflation The ECB s monetary easing during 2014 resulted in a significant euro weakening, but fundamental factors are supportive for EUR/USD The effective euro weakening supported core inflation in 2015, but the stronger euro will give headwind to core inflation in 2016 Source: Bloomberg, ECB, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets 16

Fixed income market reaction adapting to a new lower bound The combination of the rate cuts, forward guidance, expansion of the QE through purchasing non-financial corporate bonds and the new TLTRO II is a strong signal that policy is going to be very accommodative for a long period ahead. However, the reaction in the fixed income market was on various accounts not really responsive as we saw yields rising especially in the front end of the curve, and the euro strengthening. Furthermore, the intra-days moves is a clear signal that ECB is not being very transparent on the new measures. Looking forward then the short-term rates are anchored down at 40bp, and with the possibility of borrowing at possibly very close to the deposit rate at the TLTRO II should put pressure on lending rates towards the deposit rate as seen e.g in Sweden. However, if -40bp is the new low as -20bp was in the past then we did have factored in more easing but this is now being taking out of the curve. The big question is whether banks will expand their balance sheet at the new TLTRO II or will they just be used to roll-over existing TLTROs. Here we are still in the dark. The curve should gradually flatten as investors, banks etc. seek further out on the yield curve with the front-end being anchored. However, the risk is that this is seen as the last measures from ECB and with the nervousness regarding the euro area then we could see a sell-off from the long end. Bund-, Bobl-spreads should continue to tighten with possible avalanche of new issuance in the corporate bond market. Initially, we saw a big decline in the ITRX EUR IG CDS index from above 90bp and down 80bp. Later the market stabilized at 85bp. Given the added uncertainty regarding the outlook for Bunds, while EU swaps is being anchored, then our 30 to 40bp trading interval for the Bund spread should be maintained. Peripheral spreads to core-eu should also benefit from the new measures and the added liquidity from the TLTROs as well as the expansion of the QE. We saw a solid tightening today, and more is expected to come even though the ECB measures announced today will not short-term change the perception of the core versus peripheral spreads. Furthermore, the political uncertainty will also be a factor that today s policy announcement does not take care off. In terms of inflation markets the moves were also zig-zag. Ahead of the ECB meeting 5y5y inflation swaps traded around 1.48% and during the press conference increased to just above 1.53% before ending the day around 1.49%. Jens Peter Sørensen, Chief Analyst, jenssr@danskebank.dk, +45 45 12 85 17 17

FX market reaction initially lower, but eventually higher EUR/USD initially moved lower to 1.085 as the boost to risk appetite dominated the move higher in short-end EUR rates, but this was later reversed and EUR/USD surged close to 1.11 after Draghi effectively ruled out further rate cuts. Thus, while the move in relative rates was indeed EUR supportive as we expected, the extensive easing measures announced to some extent counteracted this and first weighed on the single currency given its status as a funding currency. The fact that the ECB did not take this opportunity to implement a two-tiered deposit system is a fundamental EUR positive, as it suggests this potential source of downside to the currency via a continued downward pressure on the money-market rates has been taken off the table (for now, at least). Thus, rather than attempting to fight disinflation by bringing about currency weakness, the ECB now appears to target rather forcefully fixing the bank-lending channel, i.e. credit volumes rather than the price hereof directly (i.e. interest rates). Indeed, in our view, it is increasingly difficult for the ECB to bring about further EUR /USD downside given that the cross is stretched on positioning and fundamentals alike. Going forward, the key sources of potential downside in the cross will derive from a continued improvement in risk sentiment and/or markets pricing in Fed hikes more aggressively. While this could lend support to USD near term, we maintain that EUR/USD will be range-bound on a 1-3M horizon around the 1.10 level and headed higher thereafter still targeting 1.16 in 12M. With EUR/CHF higher and again close to 1.10 coupled with an ECB that effectively rules out more rate cuts, the pressure on SNB to deliver lower rates is limited. Thus, we maintain that the SNB will stay put on rates at its quarterly meeting next week contrasting with market pricing (albeit some rate downside has been priced out today) and handle any unwanted CHF strength via intervention. This keeps EUR/CHF on track for possibly some limited downside near term but a continued move higher towards 1.15 in 3-12M. Cristin Tuxen, Senior Analyst, tux@danskebank.dk, +45 45 13 78 67 18

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