Investment Research General Market Conditions 4 February 2014 Flash Comment ECB preview: Another refi rate cut At the ECB meeting last month, Mario Draghi described two scenarios that would lead to action. We saw both of these triggers materialise in January. Therefore, we expect the ECB to ease again on Thursday. Inflation below the ECB s projection Euro inflation declined again in January and it is now almost certain that inflation in Q1 will be below the ECB s December staff projection. This negative surprise combined with declining inflation expectations means the pressure on the ECB to ease further is high. The higher money market rates seen in January are a second concern for the ECB. In the absence of a policy response and with excess liquidity at the current level, we believe it is likely the volatility in the money market will persist. Moreover, the case for further ECB action has been strengthened by the data for monetary development, which showed a further weakness in December. Bank lending remains alarmingly weak and signs of a turn for the better are fragile. Source: Eurostat, ECB, Danske Bank Markets Higher short-term money market rates The most likely response is a refi rate cut to 0.1%, while keeping the deposit rate unchanged at 0%. The Governing Council may also consider stopping the sterilisation of SMP purchases, which would increase the liquidity surplus by almost EUR180bn. Even though the EONIA market is pricing some probability of further easing from the ECB, we would expect a refi rate cut to result in a decline in moneymarket rates. Moreover, we see good potential for a move lower in EUR/USD. More easing from the ECB At the ECB meeting last month, Mario Draghi described two scenarios that would lead to action: (1) an unwarranted tightening of the short-term money markets and (2) a worsening of ECB s medium-term outlook for inflation. In the meantime, both of these scenarios have materialised (see below). With the arguments in favour of further easing we believe that the Governing Council will act now. This said, it is a close call and there is a fairly high risk that Draghi will choose a wait-and-see approach and deliver nothing but a dovish tone on Thursday. The preferred tool when both triggers have materialised is probably a refi rate cut. We think the most likely scenario is that the ECB chooses to bring the refi rate down to 0.1%. This could have a positive impact on inflation and, at the same time, help to push shortterm money market rates down. A simultaneous deposit rate cut to negative is a possibility. Draghi has repeatedly said that the ECB is technically ready and in November he indirectly said that a deposit rate cut was the preferred tool if inflation remains low. However, in the meantime it seems that he has become more open minded as in January he said the Governing Council is ready to use all the instruments that are allowed by the Treaty. A simultaneous deposit rate cut seems most likely if the Governing Council focuses on the deflation scare, while it seems less useful in addressing money-market tensions. We think the ECB will keep the deposit rate on hold on Thursday. Senior Economist Frank Øland Hansen +45 45 12 85 26 franh@danskebank.dk Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Senior Analyst Peter Possing Andersen +45 45 13 70 19 pa@danskebank.dk Senior Analyst Cristin Kyrme Tuxen +45 45 13 78 67 tux@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com
Non-standard measures may also be considered The Governing Council may also consider using non-standard measures. The most plausible instrument would be to stop sterilising SMP bond purchases. This would add almost EUR180bn to excess liquidity and should thus reduce money-market tensions and help to lift inflation. If SMP purchases are no longer sterilised, it would de facto be quantitative easing. Nevertheless, an article in The Wall Street Journal has suggested that the Bundesbank is in favour of this move. If this is indeed the case, it seems quite likely that the Governing Council will soon go ahead with this step. This is further supported by Draghi who, according to Bloomberg, said that he would contemplate halting the absorption of liquidity from the SMP purchases if the Bundesbank openly backs this. An alternative instrument is a funding for lending scheme where the ECB purchases bundles of bank loans. This should help to increase bank lending, which could lift growth and the inflation outlook. The problem with this instrument is that the market for securitised bank loans is very limited in the euro area. Draghi might use this instrument to signal intentions of further easing down the road but this instrument is unlikely to have a significant effect in the short term. The ECB could also abandon the minimum reserve requirement, which would free up about EUR100bn on banks balance sheets. The reserve ratio was lowered from 2% to 1% in January 2012. There has been no signal indicating the ECB is about to take this step. Not the end of ECB s easing cycle Even if the ECB cuts the refi rate or eases further through a non-standard measure, we expect Draghi to continue signalling that the ECB is ready to ease again. When the ECB lowered the refi rate in November last year, the Governing Council reviewed the forward guidance and confirmed that it expected interest rates to remain at present or lower levels for an extended period. Our forecast for inflation currently suggests that inflation will remain below 1% until mid-2015 and as Draghi has described this as a danger zone, we expect the ECB to continue considering further easing measures. This is supported further by the ECB s Benoît Coeuré, who last week said that the ECB can lift inflation even if rates are close to the zero lower bound. Draghi has previously indicated that the ECB will cut the deposit rate to negative if the inflation rate stays low and this might still be the preferred instrument if inflation triggers more easing looking ahead. What is most important is that we expect the discussion about further easing to continue for some time. Inflation is below ECB s projection Euro inflation declined to 0.7% in January, from 0.8% in December and is now back at a cycle low. Looking ahead, we expect inflation to remain at 0.7% in February and fall to 0.5% in March (see Flash Comment: More pressure on the ECB from low inflation, 31 January). Compared with the ECB s forecast for inflation, this is well below its projection of inflation being around 1.0% in Q1 and it suggests that the fall in inflation in January came as a surprise to the ECB. In our view, the ECB will not wait for another negative surprise but act in accordance with its mandate and its forward guidance. Furthermore, the fall in inflation in January, together with the outlook for Q1, is likely to imply that the ECB will lower its inflation forecast for 2014 when it is released at the ECB meeting next month. We expect a refi rate cut this week and Bloomberg Stop sterilising SMP bond purchases Reduce reserve requirement Inflation below 1% until mid-2015 and Danske Bank Markets 2 4 February 2014 www.danskeresearch.com
Inflation too far below the ECB s 2% target is likely to increase concerns about a deanchoring of inflation expectations. Even though Draghi will repeat that inflation expectations remain well anchored, the ECB is probably concerned about the continued decline in market-based inflation expectations. The pricing of the 10-year euro inflation swap is 1.71%, which is close to the previous lows seen in 2008, 2010 and 2012 and this is another important argument for the ECB to ease on Thursday. Short-term money-market rates have increased The second scenario that would cause further easing was an unwarranted tightening of the short-term money market rates. During January, the EUR money market received a lot of attention as the EONIA fixing came out above the refi rate for four consecutive days. Even though extra liquidity from MRO auctions and a partly failed SMP drain pushed money market rates lower again, the EONIA is still fixing relatively close to the refi rate. Following the elevated levels of the EONIA fixings, the ECB s Klaus Knot said that there was no need for the ECB to take action to calm money markets and the risk is that Draghi does not see the situation as unwarranted. However, with the excess liquidity at the current level it is likely that volatility in the EONIA will persist in the absence of a policy response and Draghi has previously said the ECB would respond to this. Market-based inflation expectations continue to decline Higher EONIA fixings during January Tight credit conditions is also a concern Data for monetary development showed weakness again in December. Regarding the decline in bank lending, this should be due partly to banks attempts to deleverage ahead of the ECB taking its snapshot of their balance sheets for the Asset Quality Review and it might improve in 2014. However, signs of a turn for the better are fragile and the current weak lending seems to be a concern for the ECB as Draghi recently said he would be open to the ECB buying packages of bank loans to the private sector. and Bloomberg Tight credit conditions still a concern Market expectations Fixed income We believe that the EONIA market is currently pricing some probability of further easing from the ECB. This could be in the form of an isolated refi cut, a parallel cut in the refi and the deposit rate, a decision not to sterilise the SMP programme, a removal of the reserve requirements or a combination of these. However, none of this seems to be fully priced and, therefore, we would expect money-market rates to decline in all of the possible outcomes described above. The biggest impact on money-market rates would come from a cut in the deposit rate or a decision to increase excess liquidity either by not sterilising the SMP or by removing the reserve requirement to zero. As longer term interest rates have already declined measurably and many already expect the ECB to ease, we believe the impact further out on the curve would be moderate in most outcomes. If the ECB decides not to act, the relatively heavy positioning for lower rates in the money market and the short end of the EUR swap could be of some concern. However, the crucial thing in this scenario would again be whether Draghi is able to sound sufficiently dovish to keep the money market in check. FX Although market expectations have seemingly adjusted towards an early ECB refi cut in recent days, we nonetheless see good potential for a move lower in EUR/USD if the ECB delivers on rates this week. First, a cut (even if only on refi) would signal that the ECB is getting even closer to scrapping the mental barrier to rates close to (and even below) the Some probability of easing is priced, but money market rates should go lower 0.50% 0.40% 0.30% 0.20% 0.10% Pricing EUR-OIS 1m swap 0.00% Jan14 Jul14 Jan15 Jul15 Jan16 3-Feb-14 10-Jan-14 Current policy rate Source: Danske Bank Markets 3 4 February 2014 www.danskeresearch.com
zero line; this would be important in opening up the range of possible outcomes on rates, which is arguably constrained on the downside at present. Potential for a move lower in EUR/USD Second, it would signal that the Draghi leadership indeed intends to act swiftly when the ECB is challenged on its core mandate of price stability, both on the up- and the downside; this more symmetric approach to the inflation mandate was notably seen with the surprise cut in November, which was also a reaction to softer-than-expected inflation. A February cut would remind markets that the long-standing German aversion on upside inflation risks has less impact on the ECB s willingness to act these days. Finally, speculative positioning in the FX market from last week shows that investors have recently moved towards EUR longs and unwound JPY and CHF shorts rather than put on more USD longs during the emerging market sell-off. Thus, while this picture may have been partly reversed in recent days, positioning in itself suggests potential for a move lower in EUR/USD in the near term. Thus, we would not be surprised to see EUR/USD test the strong support level at 1.3390 on an ECB refi cut this week. and Bloomberg 4 4 February 2014 www.danskeresearch.com
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