Global Daily – Can the ECB achieve shock and awe?

by: Nick Kounis

ECB View: Size of asset purchases is where there is room to surprise – The ECB has signalled strongly that it intends to announce a package of monetary easing measures at its September meeting. In this Daily Insight, we set out what we expect the ECB to announce relative to market and analyst expectations.

Rate cuts – We expect the ECB to cut all its policy rates by 10bp at the September meeting, followed by another 10bp step at the December meeting. Both moves are more than priced in by financial markets. Economists – according to the Bloomberg Poll – expect a 10bp cut in the deposit rate in September, but no change in December. For the ECB to surprise on the upside, it would need to cut policy rates by 20bp next month. However, it will likely be reluctant to do so. As it moves policy rates into unchartered territory, with uncertainty about the impact of more deeply negative rates on banks and the transmission mechanism, it may well decide to move in smaller steps. The last four ECB reductions in the deposit rate have each equalled 10bp, probably reflecting this reasoning.

Mitigating measures – The ECB is likely to announce measures to mitigate any adverse effects on the banking system of negative interest rates. The Governing Council explicitly mentioned a tiered deposit rate system in its July monetary policy statement and as such it looks likely to announce one. If a tiered deposit rate system is seen by investors as a framework that will facilitate a much more aggressive reduction in policy rates, it could further fuel expectations of rate cuts. However, we think ECB President Draghi might be cautious in his communication on this topic as a tiered deposit rate system alleviates only the direct cost of negative rates for banks. A key issue banks face is a squeeze of the margin between lending rates and retail deposit rates, and a tiered deposit rate system does not provide much relief on this front. Meanwhile, the ECB may decide to make the conditions for the TLTRO programme more generous, by reducing the lending rate (by removing the 10bp spread over the refi rate for the upper rate and 10bp spread over the deposit rate for the lower rate) and potentially increasing the maturity of the loans.

Net asset purchases – We expect the ECB to announce a EUR 70bn per month programme running for a year from October 2019 onwards. It could signal a higher share of corporate bond purchases and agency and regional bond buys than in its first programme (the latter by raising the issue(r) limit for these securities). We think this is the main area where the ECB could surprise market expectations and achieve some degree of ‘shock and awe’. The consensus of the latest Bloomberg survey of economists is a smaller programme of EUR 40bn per month running for 12-months.

Forward guidance – Following the 10bp deposit rate cut, we think the ECB will continue to signal that its key policy rates could be cut further through its forward guidance. In addition, given the re-start of net asset purchases, it could once again link the horizon to the period of QE. So the Governing Council could state that it expects the key ECB interest rates ‘to remain at their present or lower levels well past the horizon of net asset purchases, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to our aim over the medium term’.  This would signal interest rates would remain on hold or lower at least until early 2021. The current guidance is the first half of 2020. Despite the extension, markets already expect the ECB to cut rates and keep them low through 2021, so it would unlike fuel a reduction in market rate expectations.

Review of inflation aim –  The ECB has signalled that it has started discussing possible changes to its inflation aim. One possibility is that it announces the start of a formal review. We do not expect such an announcement at this stage. We think it is something that ECB President Mario Draghi will leave to his successor. (Nick Kounis)