ECB Cut: Pushing On A String

Hamstrung by a restrictive mandate that prevents discretionary intervention, the European Central Bank has, in recent years, been forced to exploit loopholes in its statute and adopt a gritted teeth approach to monetary policy. As a result, official policy has been cumbersome and reactive, rather than flexible and proactive. With this in mind, it came as a surprise that the ECB opted to cut the refinancing rate by 25bps to 0.25% on November 7, which atypically caught the market off guard. While consensus had been converging on the assumption of a cut by end-year, many (ourselves included) were leaning towards a December policy move. In the immediate aftermath of yesterday's decision, the euro plunged to US$1.34/EUR and equities broadly rallied. The euro could have a bit further to slide in the short term, but we expect any relief for the export sector to be proved short-lived absent a more fundamental stimulus from the ECB.

Deflation Fears Prove To Be The Key Trigger

There are several dynamics at play which have forced the ECB's hand at the November monetary policy meeting. For one, the euro has proven stubbornly strong throughout 2013 (we had turned more bullish the euro at the beginning of the year), raising fears that the nascent economic recovery could be choked off before gaining any momentum. In addition, the ECB has become increasingly concerned about the possibility of an 'LTRO cliff' as euro area banks have been steadily repaying the loans acquired in December 2011 and February 2012, ahead of the three-year maturation.

Recent Refi Cut May Have Little Traction
Eurozone - Refi Rate Moves (Vertical Axis) & % EUR Change 7-Days Either Side Rate Move (Horizontal Axis)

Hamstrung by a restrictive mandate that prevents discretionary intervention, the European Central Bank has, in recent years, been forced to exploit loopholes in its statute and adopt a gritted teeth approach to monetary policy. As a result, official policy has been cumbersome and reactive, rather than flexible and proactive. With this in mind, it came as a surprise that the ECB opted to cut the refinancing rate by 25bps to 0.25% on November 7, which atypically caught the market off guard. While consensus had been converging on the assumption of a cut by end-year, many (ourselves included) were leaning towards a December policy move. In the immediate aftermath of yesterday's decision, the euro plunged to US$1.34/EUR and equities broadly rallied. The euro could have a bit further to slide in the short term, but we expect any relief for the export sector to be proved short-lived absent a more fundamental stimulus from the ECB.

Recent Refi Cut May Have Little Traction
Eurozone - Refi Rate Moves (Vertical Axis) & % EUR Change 7-Days Either Side Rate Move (Horizontal Axis)

Deflation Fears Prove To Be The Key Trigger

There are several dynamics at play which have forced the ECB's hand at the November monetary policy meeting. For one, the euro has proven stubbornly strong throughout 2013 (we had turned more bullish the euro at the beginning of the year), raising fears that the nascent economic recovery could be choked off before gaining any momentum. In addition, the ECB has become increasingly concerned about the possibility of an 'LTRO cliff' as euro area banks have been steadily repaying the loans acquired in December 2011 and February 2012, ahead of the three-year maturation.

A Looming LTRO Cliff?
Eurozone - Proportion of Outstanding LTRO Funds Repaid

We have also highlighted the sharp drawdown in excess liquidity at the ECB at a time when banks could be forced back into the interbank market. This could risk triggering a rise in secured and unsecured repo rates, as well a volatility breakout across the fixed income space, which has hitherto enjoyed a welcome period of tranquillity since ECB President Mario Draghi unveiled the OMT facility in 2012.

Excess Liquidity Draining From The ECB
Eurozone - ECB Excess Liquidity & EONIA

While these concerns have engendered a more dovish bias at the ECB in recent months, we believe that the fear of deflation has been the key trigger motivating the refi rate cut. The latest inflation print for October came in at 0.7% y-o-y, following a persistent deflationary trend since the tail end of 2011. Since the global financial crisis, central banks in the heavily indebted developed world have appeared to be far more concerned with the risk of deflation rather than inflation. While spiralling inflation exerts substantial costs on the economy, a modest degree of positive inflation is beneficial for sustainable economic growth. Deflation, however, severely undermines the debt-financed financial system and goes hand in hand with economic stagnation. The short-term benefit of a consumption subsidy (in the form of rising purchasing power) is quickly offset by the tax on productive investment (through rising real rates). Ultimately, expanding output proves too onerous in an environment of falling prices. Moreover, once deflation sets in, it can be extremely difficult to overcome. As such, should headline inflation continue heading south, we would expect to the ECB to become more emboldened and push for more substantial stimulus.

Edging Closer To The Deflationary Danger Zone
Eurozone - Inflation Momentum

Negative Depo Rate Still A Possibility

As we alluded to above, reducing the refinancing rate will have little tangible effect in the markets or on the broader economy. EONIA (Euro Overnight Index Average) rates have long detached from the refinancing rate as the largest chunk of liquidity provision from the ECB now comes from its long-term refinancing operations (LTROs) rather than the main refinancing operations (MROs), which are connected with the refi rate and were the dominant form of liquidity supply before the economic crisis. EONIA rates now track the deposit facility rate (which sets the floor for the official policy rate corridor) and so a cut to the refi rate will be more of a technical (or cosmetic) adjustment rather than a genuine stimulating move.

Squeezing The Policy Rate Corridor Will Do Little To Coax Down EONIA
Eurozone - ECB Policy Rates & EONIA, %

We have argued for some time ( see our online service, October 2012,"The Evolution of the Monetary Transmission Mechanism") that EONIA decoupling means that the only traditional policy tool with any traction in the money markets is the deposit rate. Indeed, given the aforementioned transition from MROs to LTROs which has rendered the refi rate ineffectual, the ECB can only hope to influence the term structure by adjusting the deposit rate, which at this point would have to go negative.

Modest Flattening Of The EONIA Curve
Eurozone - EONIA Curve, %

With little in the way of empirical support, such a move would mean wading into unchartered waters. A negative deposit rate would be an extremely unorthodox measure that would jolt the markets and send the euro tumbling. At this point in the cycle, this is the only feasible way of using the central bank's policy rates to coax unsecured lending rates lower and deliver a substantial stimulus. However, in fundamentally reversing the traditional operation of the market by introducing a negative cost of carry on depositors, the ECB could risk major upheaval in the banking system. In particular, money market funds, which supply the banking system with liquidity and rely on positive deposit rates, would be thrown into disarray. A significant drawdown in banking sector deposits would be possible, which in turn would mute any stimulating benefit from a weaker euro and forced lending on the asset side. This huge uncertainty suggests to us that while a negative deposit rate will be on the cards as long as the spectre of deflation looms over the eurozone, it would only come to fruition as a last ditch measure if the ECB is unable to provide more OMT or LTRO-type support.

The ECB has suggested providing further LTRO funds as a means of bridging a potential liquidity cliff. Despite the recent rhetoric to that effect, it may be difficult to implement given the central bank is due to conduct a major Asset Quality Review (AQR) beginning in March. Banks may be stigmatised by taking additional funds, with only the weakest credit institutions (that are less able to ramp up private sector lending) likely to take up additional liquidity from the ECB. Nonetheless, time could be running out for the central bank to react to unfolding disinflationary developments, which suggests that further easing will be on the way in some form or another. The most likely candidate in the near term would be the Supplementary Long-Term Refinancing Operations (SLTROs) which can provide short duration liquidity on a more ad hoc basis.

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