ECB research Implications of the ECB easing measures

Investment Research General Market Conditions 5 June ECB research Implications of the ECB easing measures The ECB surprised the markets by boosting liquidity through a new 4Y targeted LTRO (TLTRO) while at the same time cutting the refi and deposit rates, bringing the latter into negative territory. We take a closer look at the implications of these measures. While it is difficult to judge how much the TLTROs will indeed boost liquidity we believe it will be by a significant amount. The combination of negative rates and rich liquidity will support performance in peripheral markets, lead to lower money market fixings, steeper yield curves, higher break-even inflation and lower EURUSD cross currency basis. The forward looking message from the ECB meeting was that the announced measures will take some time before the macro economic implications are seen. Hence, the markets should not expect much more for now, although the ECB is there, if needed. Overview of policy measures Policy action Impact Surprise Rate cuts Liquidity Communication Source: Danske Bank Markets Refi rate -10bp to 0.15% Lowers the rate on MRO and LTRO by 10bp No Deposit rate -10bp to -0.1% Eonia O/N could become negative Small surprise Marginal lending rate - 35bp to 0.40% Eonia 0/N capped at 0.40% Fixed rate, full allotment tenders at least until end-16 Strengthening of forward guidance Discontinue with 1M LTRO SMP holdings will no longer be sterilised. Final auction to be allotted on 10 Jun Limited impact since other facilities in place Should boost excess liquidity by the outstanding amount in the SMP (EUR165bn as of 30 May '14). In reality the boost is smaller since SMP drain has failed the past weeks Larger than expexted No Yes, but limited impact Targetted LTRO up to 4 years Boost to liquidity in the Eurosystem Minor surprise Extending existing eligibility of additional assets as collateral Prepare further on ABS purchases Guidance on lower bound Lower inflation forecasts on all time-horizons Ensure enough collateral avilable for TLTROs Market already knew the ECB was doing prepartory work on ABS purchases, so no real impact yet In practise the lower bound is reached, so max another 10bp cut. Limits downside to Eonia forwards The ECB inflation forecasts are now more credible No No suprise given LTROs Neutral Minor surprise No Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Senior Analyst Anders Møller Lumholtz +45 45 12 84 98 andjrg@danskebank.dk Senior Analyst Lars Tranberg Rasmussen +45 45 12 85 18 laras@danskebank.dk Analyst Anders Vestergård Fischer +45 45 13 66 41 afis@danskebank.dk Important disclosures and certifications are contained from page 6 of this report. www.danskeresearch.com

Reserve requirement Refi rate 0.15% Deposit rate -0.10% Deposit rate -0.10% ECB research Negative rates and the hot potato The ECB cut all policy rates and introduced a negative deposit rate. The negative rate will apply to reserve holding in excess of the minimum reserve requirements. This was not the case in Denmark, where the current account was expanded to limit the economic impact of the negative rate. This should be seen in light of the Danish aim of introducing negative rates, which was to safe-guard the fixed-exchange rate and not to stimulate the economy, see ECB research #4: Implications of negative rates the Danish experiences. A negative deposit rate will drive down yields. The mechanism can be explained as a hot potato that is passed between investors with no one wanting to be the one getting burnt by placing the excess liquidity at negative with the central bank. The search for yield should also help reduce fragmentation, as strong banks would lend to weaker banks instead of paying negative rates at the ECB. Hence, the hot potato effect should stimulate growth and put upward pressure on inflation even though it hurts banks profitability. Excess liquidity to be charged negative Current Account Source: Danske Bank Markets Deposit Facility Moreover, consumption and investments will be supported by lower real rates, which are also set to be supported by higher inflation expectations. The easing from the ECB should also limit the upside risk to the exchange rate, hence the negative impact on growth and inflation will be lower. This follows as a weaker currency improves competitiveness and leads to higher imported inflation. Non-standard effects of a negative deposit rate A lowering of the rate corridor Banking system Real economy Bank A Lower yields Households Bank D Bank B Unintended cons. Corporates Bank C Hot potato effect Leverage effect Negative rates Source: Danske Bank Markets, Danske Bank Markets Targeted LTRO to increase bank lending With the introduction of a series of targeted longer-term refinancing operations (TLTROs) the ECB is accommodating the liquidity situation in the Eurosystem. The TLTROs are split into two: 1. In the initial allowance banks will be able to take 7% of the total amount of their loans to the euro area non-financial private sector, excluding loans to households for house purchase, outstanding on 30 April. This will happen in tember and December (TLTRO 1-2). 2. In addition to this, banks will from March to June 2016 each quarter have access to borrow three times the amount of their net lending in excess of a specified benchmark each quarter (TLTRO 3-8). All loans will mature in tember 2018, but if banks have not fulfilled certain conditions on volume of their net lending to the real economy, banks must pay back their borrowing in tember 2016. Interest rate on the TLTROs will be fixed over the life of each operation at the prevailing refi rate at the time of take-up plus 10bp. 2 5 June www.danskeresearch.com

Further details on the benchmark (net lending requirement) and technical details have not been published from the ECB. The consequences for excess liquidity are initially a boost of the amount of the SMP sterilisation (that removed EUR120bn of excess liquidity at this week s auction). But the majority of the liquidity injection will happen with the TLTROs happening each quarter starting in tember. Timeline of the TLTROs 30 April ECB June meeting TLTRO 1 TLTRO 2 Dec TLTRO 3 Mar TLTRO 4 Jun TLTRO 5 TLTRO 6 Dec TLTRO 7 Mar 2016 TLTRO 8 Jun 2016 2016 2018 Measure net lending benchmark Initial allowance 7% of eligible loans (up to EUR 400bn) Additional allowance 3x [Net lending benchmark] (size unknown) Repayment TLTRO for banks with no improvement in net lenders vs. benchmark Final repayment all TLTRO Source: ECB, Danske Bank Markets Uncertain how much the TLTROs will boost excess liquidity A big unknown that will remain unanswered for some time is: how large will the demand for the TLTRO be? (and thereby how much excess liquidity will increase). The important factors are how much collateral is available to banks and to what extent capital constraint will be an issue. (Also loan demand from SMEs is a prerequisite to get the full available amount out but improved business confidence suggests that this is not an issue). Initially, the banks could take as much as EUR400bn in total on the two initial TLTROs, corresponding to 7% of the total amount of the loans to the euro area non-financial private sector. We deem that it should be commercially attractive for any bank in the euro system to get up to four years funding at a fixed rate of 0.25% (current refi rate + 10bp). Hence, we expect a take-up close to EUR400bn. However, there is less certainty about how much this will actually lift excess liquidity as the old 3Y LTROs will expire in Jan/Feb and since there is a lot of uncertainty about how much banks will be able to take on the six additional TLTROs. Eligble loans to EA non-financial private sector Excess liquidity to be increased 3 5 June www.danskeresearch.com

Another approach to how much liquidity will be taken on the TLTRO is to ask the question: how important is it to the ECB that the TLTRO becomes a success and that the lending to non-financial corporations is increased? The answer is very much so. Mario Draghi made that clear today. This implies that collateral rules and restrictions can be adjusted down the road to ensure that the desired effect is reached. That is how the ECB s balance sheet will help facilitate increased lending to non-financial corporations. A consequence of this will be higher excess liquidity and intensified search for yield. Market impact TLTROs will drive peripheral spread compression further The ECB emphasised that the TLTRO is targeted towards increased lending to nonfinancial corporations i.e. to support the real economy implying that the TLTROs should not be used for carry trades. There are, however, no mechanisms preventing the banks from doing so in the first two years. The hot potato effect should be boosted by the negative deposit rate and drive continued spread compression as the hunt for yield is intensified. So, despite the ECB putting its focus on the impact of increased lending to non-financial corporations, the positive side effect for peripheral markets is more excess liquidity that banks will compete to get rid of. Today s measures from the ECB will also act as a significant confidence booster but it could take some time before we see the full effect. We have previously seen that it can take months before a change in market perspective/confidence has fully taken effect. That was, in particular, the case following the OMT announcement, but also to some extent the previous LTROs. This time it could take even longer as we will have to wait until tember for the first TLTRO. In short, we deem it likely that the peripheral market will rally further on the new ECB measures over the next months. Search for yields should drive periphery bond yields lower Source: Macrobond, Danske Bank Markets B/e inflation to move higher Lower money market fixings We expect the Eonia O/N to decline towards zero in the coming weeks as excess liquidity is lifted by ~EUR120bn when the SMP is no longer sterilized. Eventually, when the initial TLTROs are settled we could see a moderately negative Eonia O/N. Meanwhile, a 10bp deposit cut is probably not enough to drive Euribor fixings down to negative territory due to a positive credit spread. We expect a decline in the 3M Euribor towards 0.10%, possibly a tad lower. EURUSD cross currency basis should also move lower due to the richening of EUR liquidity. Steeper swap curves ahead Steeper curves and higher b/e inflation Going forward we expect steeper yield curves. The anchoring of the short-end has been enhanced, and the long-end should move higher as growth and inflation expectations are expected to increase. In addition we expect higher US rates in the coming quarters, which should also rub of the EUR rates due to high correlations. It is also our view that that break-even inflation should increase from current very low levels. Especially around the 5Y segment we see value in paying fixed inflation. EUR/USD to move lower The combination of interest rate cuts in addition to the various liquidity measures is overall euro negative. The market may have to digest the details of the of measures listed by Draghi, but overall, today s stimulus package by the ECB will add to the monetary policy divergence between the euro area and the US as the ECB remains clearly committed to keep a strong easing bias, while the first Fed rate hike slowly moves closer. This should continue the downtrend in EUR/USD, which we forecast at 1.28 in 12M. 4 5 June www.danskeresearch.com

A significant package to mark end of easing According to Draghi, the ECB has reached the lower bound on interest rates and only little technical adjustments are left. This was also reflected in the ECB s forward guidance, which is now the key ECB interest rates will remain at present levels for an extended period of time, hence lower levels of interest rates were excluded. The weakening of the forward guidance was a bit of a disappointment, as by crossing the invisible line of a negative rate the ECB could signal further deposit cuts could be priced. The ECB strengthened its communication about off-balance bank lending measures as it will intensify preparatory work related to outright purchases in the ABS market. The purpose with such an instrument would be to improve the transmission mechanism. This is also the aim of the TLTRO, but it only provides funding and does not solve undercapitalisation of banks. Hence, if the ECB later on judges that banks lending capacity is constrained due to capital requirements, we expect the next step from the ECB to be purchases of ABS loans. But if the ECB observes any improvements in bank lending, it will not go down that route, as it implies the ECB has to take the credit risk. Any other easing measures besides ABS purchases will not be announced within the next year, in our view. Draghi said today there will be delayed effects on the real economy and according to him, the impact attributable to the new programme, will probably take three-four quarters. Hence, even if inflation remains around the current level over the coming months (i.e. does not decline further unexpectedly), the ECB will abstain from easing while it waits for the impact. Even though the ECB will not ease within the next year, it still indicates it is ready to do more and according to Draghi if need be, we aren t finished here. Apart from ABS purchases, the only instrument which seems to be left in the toolbox is QE. The ECB signals that it is ready for that and the statement says the Governing Council is still unanimous in its commitment to unconventional instruments. However, we continue to believe the bar for a broad-based QE programme is very high and we still believe it requires a worsening of the medium-term outlook for inflation. The ECB lowered its inflation projection on all horizons. It was a bit surprising the 2016 projection was lowered and that inflation is now only set to reach 1.5% in Q4 16. In the new projection, inflation moves gradually higher from Q4 14. This is in line with our forecast, where the lagged effect of higher global food prices will lead to higher inflation. Later on the recovery should have gained strength and lower unemployment should slowly put upward pressure on inflation. Moreover, the headwind from the strengthening of the currency will fade and eventually it could lead to a higher inflation forecast. The ECB lowered its inflation projections more than expected The ECB does not expect higher inflation before Q4 14 Source: ECB, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets 5 5 June www.danskeresearch.com

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