What is the ECB to Do?

A discussion of what the ECB is likely to do at Thursday's policy meeting requires an appreciation of its challenges.  There are four challenges that the ECB faces in nursing the "weak, fragile and uneven" recovery, as Draghi says.  

The two pillars of monetary policy, inflation and money supply, have been weak.  Private sector lending has been contracting for the better part of two years.  The key overnight interest rate, EONIA, has become more elevated and volatile, as excess liquidity declines, and banks borrow less from the ECB and repay LTRO borrowings.  

These challenges are taking place in a context in which the deposit rate, the lower end of the rate corridor, is already at zero.  The repo rate stands at 25 bp.  Draghi has argued that there are signs that the lending may be turning.  The PMI survey show the economy is continuing to recover, with the composite February PMI, released earlier, rose to its best level since mid-2011

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 These factors, in addition to news that disinflation forces stabilized, with the most recent print (preliminary February reading), offer powerful arguments against extreme, emergency measures, like outright sovereign bond purchases or taking the unprecedented step of a negative deposit rate. 

Many who are a calling for a negative deposit rate, now or next month, do not seem to appreciate the potential for serious financial disruption, for governments, banks and other financial institutions. It is not clear how a negative deposit rate would address the four challenges we identified, and could be counter-productive.  

Among the more popular calls is for a 10-15 bp cut in the repo rate.  The repo rate at 25 bp is not a problem.  The ECB cut the repo rate by 25 bp in Q4 13, and it did not ameliorate any of the ECB's challenges.   A 10-15 bp rate cut will not enjoy greater success.  Moreover, it is not the key rate in the current environment.  EONIA has traded above it.  It would largely be a symbolic move, and by that we mean that it would likely have minimal impact on the euro and market rates.  

In order to reduce the volatility and level of EONIA, there are two measures the ECB can take.  The first is to reduce the  top of the rate corridor.  It is the lending rate, which is now set at 75 bp.  Even in the face of strong year-end pressures, EONIA did not rise above 45 bp.  Reducing the lending rate 25 bp would also be more useful as a signaling device, and would prevent larger spikes in EONIA, as the ECB's balance sheet shrinks and excess liquidity in the banking system is absorbed.  

The second measure that could be used to reduce the volatility and level of EONIA is boosting the excess liquidity in the banking system.   Recall, the excess liquidity was boosted by the LTRO borrowings.  The excess liquidity peaked in March 2012 near 813 bln euros.  As banks began repaying the LTRO borrowings, the excess liquidity has fallen.  It fell below 200 bln euros last October and this was seen as the level necessary to keep EONIA pinned near the lower end of the rate corridor (zero deposit rate) and now stands near 134 bln euros.  

In turn there are two ways the ECB can boost excess liquidity.  The first is to offer a new LTRO. The problem with this is that there would likely be a stigma attached to the borrowing, which there wasn't initially.  It might not be taken up.  And if it is taken up, it would not necessarily boost private sector lending. 

It is the second way that is receiving more attention.  It is to formally stop sterilizing the previous bonds purchased under the SMP initiative by Trichet.  There have been weeks in which there is not sufficient participation for the ECB to drain the full amount.  However, it has managed fully sterilize the SMP for the past five weeks.  This, in effect drains 175 bln from excess liquidity.  If they stopped, it would boost excess liquidity.

Trying to get the lay of the land, we saw the Bundesbank was opposed.  The sterilization was how Trichet sold it (SMP) as not being QE.  Remember too, Weber and Stark resigned from the ECB over the even sterilized operation.  And now, the BBK has testified before the German Constitutional Court that even the more rule based OMT sovereign bond purchases that Draghi has floated, is in violation of the ECB's charter.   Nevertheless, reports suggest that the BBK has dropped, or at least softened, its insistence on sterilization.  

This seems to raise the likelihood, perhaps more than we previously anticipated, of a formal decision to stop sterilizing the SMP.    We suspect that such an addition to excess liquidity could drive EONIA down around 10 bp or a little lower.  It could spark a quick down move in the euro, which we'd expect to be short lived.   Some observers may argue that end of sterilization shows the ECB is willing to consider outright QE.  This is a reasonable extension of the argument, but we do not accept it.  

Stopping the sterilization of SMP does not bring a new QE program closer.   There are legal and political difficulties.  OMT allows for the purchase of sovereign bonds, but only under certain conditions.  None of the potential candidates, such as Italy or Spain, are at all inclined to do so.  Moreover, there is a lack of urgency with bond yields at record or multi-year lows.  Draghi has talked about buying bank bonds, not sovereign bonds, and even then only backed by new lending to small and medium sized businesses or households. There are a number of technical steps that are necessary and neither the ECB nor these conditions are ready yet. 

The ECB's staff is also going to extend the economic forecasts out to 2016.  It is this channel that ECB can be expected to signal that while inflation will likely be low for a protracted period,  deflation through the euro area as a whole is unlikely.  We continue to believe that deflation in some peripheral countries is not the same thing as deflation in EMU, and it is a sign that the system is working.  This is that countries in the periphery are regaining competitiveness through a decline in internal prices rather than a currency devaluation.  

Any disappointment with the ECB will likely be expressed by pushing the euro higher, while new initiatives can see the euro dip.  However,  given the still unsatiated appetite for yield and perceptions that many European equity sectors are relatively cheap compared to the US, we anticipate a euro pullback to be brief.    We peg initial support just below $1.3700 and then $1.3650.  Only a move below $1.36 would undermine this relatively constructive outlook.  On the upside, we see potential for the euro to challenge the $1.40 area.