Global Daily – Sticking to our conviction on large-scale QE

by: Nick Kounis

ECB Preview: A package of measures, with QE the highlight – We expect a package of monetary stimulus from the ECB on Thursday. Below we set out the main elements we expect relative to analyst and market expectations. Given the pullback in ECB stimulus expectations over recent days, we think there is considerable room for a market surprise on the size of net asset purchases, which will push yields lower, curves flatter and sovereign and credit spreads tighter.

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 (14bp by September and a cumulative 23bp by the end of the year). Economists – according to the Bloomberg Poll – expect a 10bp cut in the deposit rate in September and an additional one in December. For the ECB to surprise on the upside, it would need to cut policy rates by 20bp on Thursday. 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 were to be 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 30bn per month running for 12-months.

Why do we stick to a far-above consensus view on the size of QE given hawkish comments from officials and market scepticism? Well, two reasons. First, the hawkish comments from officials have come mainly from hawkish Governing Council members who were always likely to oppose such a programme and have done so in the past (see here). Second, the current projection for inflation at the end of the forecast horizon is 1.6%, but it would very likely be revised downwards in the absence of stimulus. At the same time, ECB President Draghi clarified that the ECB is aiming for inflation of 1.9% in the July press conference. Effectively, the ECB might be looking to close an inflation gap of around 0.4-0.5 percentage points. Without a large-scale QE programme, it would be difficult to design a package, which according the ECB’s own estimates, would have the requisite impact on the economic outlook (for more see here).

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. (Nick Kounis)