ECB Preview: Focus on inflation, tiering and TLTROs – The ECB Governing Council meets on Wednesday in a monetary policy meeting. Given that the central bank announced a policy package in March as well as revised forecasts, major changes in tone do not seem likely. There are however three issues that are worth watching to see whether there is additional insights into the Governing council’s thinking.
Inflation – First of all inflation. Recent inflation developments emphasise the downside risks to the ECB’s inflation projections. Core inflation fell to 0.8% yoy in March from 1% in February. In addition, market inflation expectations have dropped from already low levels. For instance, the 5y5y inflation swap stood at 1.36% at the time of writing, down from 1.47% at the time of the last ECB meeting. The historical average for this series is 2.1%, while it is not far from the record low of 1.3%. Although the ECB is unlikely to change its overall message on inflation, there might be increased concern about downside risks in Mr Draghi’s commentary. The tone may well be more dovish.
Tiering – Second, investors will be focused on how far the ECB is in looking at the issue of alleviating possible future effects of negative interest rates, with speculation raging that the ECB will move to a tiered deposit rate system. ECB President Mario Draghi gave a clear signal of this in a speech at ‘The ECB and Its Watchers’ conference in Frankfurt. He asserted that ‘we will continue monitoring how banks can maintain healthy earning conditions while net interest margins are compressed. And, if necessary, we need to reflect on possible measures that can preserve the favourable implications of negative rates for the economy, while mitigating the side effects, if any’. We do not think the ECB is anywhere near making an announcement. There is no hurry as there is little evidence of major negative side effects right now (see our note here). There is also considerable doubt that the ECB will move to a tiering system over time. Such a system could be complex to design, while the benefit to bank profits is not very large (we estimate EUR 6.5 bn per annum for the whole banking system).
TLTRO-III – Third, there is a possibility that more details about TLTRO-III will be announced, though some officials have suggested that this is more likely at the June Governing Council meeting. A number of unanswered questions remain. Will the maximum amount (30% of eligible loan level) exclude current TLTRO borrowings? Will eligible loans include mortgages? Will the built in incentives include a lower rate than refi rate if a lending benchmark is met? How strict will the benchmark be? Our sense is that on these points, TLTRO-III will look very much like TLTRO-II. In particular, we think the benchmark for lending capacity will be excluding mortgages and current TLTRO loans. That would still leave an additional lending capacity of around EUR 980bn overall, though relatively modest additional amounts for Italy (EUR 31bn) and Spain (EUR 43bn). Finally, we think the interest rate on the loans will be as low as the deposit rate if banks meet certain lending benchmarks.
Outlook – Our base case is that the ECB will further push out its forward guidance on the period of unchanged policy rates and ongoing reinvestments. The modest trajectory for economic growth will not be sufficient for underlying inflationary pressures to build. We think that ECB forecasts for growth and inflation remain too high despite recent downgrades. Our base case is that ECB policy interest rates will remain on hold through to the end of 2020 and that reinvestments will continue to the end of 2021. However, the risks are to the downside and the probability is rising that the ECB will need to step up stimulus and restart QE. Market pricing on the timing of the first ECB rate hike has converged towards our base case over recent weeks. (Nick Kounis)