ECB: Delivering in December

Published on November 16, 2015

Summary: The ECB will not disappoint at its December 3 meeting despite the “assist” from a hawkish Federal Reserve and the lower Euro. Indeed, our sense is of strong consensus to cut the deposit rate  by 0.1%, from -0.2% to the -0.3% level that markets are hoping for, and quite possibly even deeper into negative territory than that, perhaps by as much as 0.2% to 0.3% to put the deposit rate at -0.4% or -0.5%. Concurrently extending the QE program beyond its current September 2016 end-date is another leading option, but an increase in its 60 billion Euro monthly pace of purchases and a broadening of the composition of purchases, while also possible, are trickier decisions to be settled at the meeting. 

At its October Monetary Policy Committee meeting in Malta, European Central Bank President Mario Draghi indicated there was a Governing Council consensus to consider further easing measures at its upcoming meeting on December 3.

Since then, the Euro has dropped from around 1.1300 to 1.0700, or roughly 5%, against the US Dollar on a combination of heightened expectations for monetary policy easing from the ECB and the growing realization the US Federal Reserve may indeed hike at their meeting on December 16 (see SGH 10/28/15, “Fed: A Hawkish Tilt”).

That assist from the Fed in weakening the Euro has raised the question of whether it takes some of the heat off the ECB for an aggressive easing policy next month. The short answer is no.

*** Even more hawkish Governing Council members are concluding that whatever the Fed does at its December 15-16 meeting, the ECB will have reasons to ease. If the Fed were to refrain from hiking, for instance, it would tighten financial conditions by bolstering the Euro. But even if the Fed were to deliver its first hike since 2006 as now expected, there would be reasons to counter its potentially dampening impact on Emerging Market economies, increasingly critical export markets for the Eurozone. ***

*** Indeed, our sense is of strong Governing Council consensus to cut the deposit rate deeper into negative territory, and that a cut could be even deeper than the 0.1% markets are expecting, perhaps by as much as 0.2% to 0.3% to put the deposit rate at -0.4% or -0.5%. Extending the QE program beyond its current September 2016 end-date is also a leading option, while an increase in its size and broadening of its composition, which are also possible, are trickier calls that will only be settled at the meeting. ***

Exploring the Real Negative Lower Bound for the Deposit Rate

As to what action the ECB may take, Draghi himself, who is at the forefront of pushing his colleagues towards additional easing measures, has stated on numerous occasions all options will be considered and are on the table, and this message has not been refuted by any of his fellow Council members on the ECB. But the (relative) lack of open dissent since the October meeting should not be interpreted as a complete all-clear from the traditional hawks of the Governing Council on the need for any and all action.

Indeed, the new, unofficial communication strategy from the ECB is to try and sort out dissent in the meetings, with a gentleman’s agreement that governors and board members should not voice any major disagreements thereafter. The message on policy direction, even if not the tactics themselves, has to be unequivocal.

It does appear nevertheless that cutting the ECB deposit rate even further than the current -0.2% level into negative territory is the policy option that is now the most widely accepted and least controversial within the Governing Council.

And most intriguingly, we believe a decision may even be made on December 3 to cut that rate by more than the 0.1% that is now hoped for in the markets, in effect testing the Eurozone’s effective “lower bound” for the negative deposit rates, perhaps by pushing the deposit rate to as low as -0.4% or -0.5%, even if that were to complicate the “corridor” spread with other benchmark rates.

The ECB may also cut the Marginal Lending Facility at the upper end of its corridor, currently at 0.30%, but may face a challenge in cutting the mid–point Refi rate below the current 0.05%. Officials point out, however, that these benchmarks are not really the only or even main drivers to market pricing of rates (and certainly not to the Euro) anyway.

QE’s Scope and Duration Also to be Considered

Draghi and his key lieutenants on the Board are also likely to push their colleagues towards a consensus on a mix of measures in December – reflecting not just the degree of actions they believe needed to address downside risks facing the Eurozone but also in line with past precedent in the Draghi-led ECB which has always taken several actions at once when it has come time to move.

We would caution that the final decisions are only going to made at the meeting, but the additional measures being considered will include elements across all three dimensions Draghi and his colleagues have flagged as possible for QE expansion – the “size, duration, and composition” of purchases.

The Bundesbank, however – which incidentally did not have an official vote at the last meeting under the new rotation system – as well as the German Bundestag have already registered their skepticism over the need for any additional QE purchases at this point.

A commitment now to extend the duration of QE purchase program beyond the currently scheduled September 2016 end-date is nevertheless the least controversial of QE easing options, and one that could meet with BUBA sign-off if need be.

If truth be told, though, extending the bond purchases beyond September next year would be something of an awkward compromise that would in fact open the door to weigh still further, potentially more powerful measures.

The thinking among some Governing Council members is that since the ECB has already maintained that QE can and will be extended beyond 2016 if need be, if the Council were to make the assessment that an extension is necessary it would be coming at what is still a relatively early stage of the initial QE program. That commitment at this point in time to these Governing Council members would be raising the question of whether an increase in the size of the monthly purchases or expansion in the scope of what assets are purchased should also be considered.

We suspect the ECB is in fact likely to also look to step up the pace of purchases beyond the current 60 billion Euro per month, and perhaps to expand the scope of the assets it will purchase, though we would attach a lower degree of certainty to that than to a deposit cut and extension of QE.

A lot will of course depend on how much support Draghi can gather for more aggressive action by then. But in order of the most to least likely of additional securities the ECB could purchase, the list would be Agencies, “Municipals” (regional and local bonds), Corporate bonds, and finally Equities, which are included on all hypothetical lists but is likely to happen, in our opinion, when pigs fly.

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