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Tuesday, 17 October 2017

ECB - Time to widen the corridor?

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A 25bp refi rate hike at this weeks ECB meeting is a consensus view given that the ECB is in a stance of “strong vigilance”. However, what is not likely in the price is the potential that the ECB will re-widen the corridor back to its normal range of 200bp from the current 150bp. This would be achieved by hiking the marginal lending rate by 50bp (to 2.50%) and leaving the deposit rate unchanged at 0.50%.

During the financial crisis the ECB surprised financial markets by narrowing the rate corridor to 150bp in order to avoid setting the deposit rate at zero. Currently with a refi rate of 1.25% the deposit rate is at 0.50% and the marginal lending rate is at 2.00%. Moving the corridor back to a 200bp spread would involve keeping the deposit rate unchanged and hiking the marginal lending rate by 50bp.

Divyang Shah, Senior IFR Markets Strategist

Divyang Shah, Senior IFR Markets Strategist

To understand what this would achieve one has to know the importance of the deposit rate during the financial crisis. Instead of the refi rate the more important benchmark for money market rates (and the floor) was the deposit rate. Despite the ECB having taken back a lot of the excess reserves in the system what remains has still been sufficient to keep market rates (in particular o/n EONIA) below the refi rate.

In this uncertain time and with the peripheral debt crisis always a trigger for contagion risks the ECB can still drive money market rates lower should this become necessary. However, by hiking the refi rate they are making their liquidity operations more expensive (still with full allotment) as well as increasing the penalty for those tapping the emergency marginal lending facility.

Think of this as the ECB still willing to play its role as lender of last resort but looking to go back to the Walter Bagehot script of lending freely at a high rate on good collateral. The ECB was certainly lending freely but this was not at a high rate or against good collateral. Over the last few months the ECB has been 1) lending less freely in the form of term money by no longer conducting 6-month or 1-year LTROs 2) increased the costs of using non-sovereign collateral especially lower rated paper and 3) hiked the cost of accepting this collateral via indexation of remaining operations to MRO.

Playing hardball with regards to not accepting Greek debt that is tainted with “credit event” or “selective default” is a part of the process of drawing a line in the sand with regards to sovereign debt. The ECB has made its contribution by relaxing rating rules for Greek and Irish sovereign debt. But the ECB does not want to be tainted as having opened up the ECB’s balance sheet to effectively debt monetization.

The advantage of widening the corridor now is that it not only allows the ECB to continue on the path of rate normalization but also react should the debt crisis take a turn for the worse. Keeping the discount rate at 0.50% means that if the ECB has to inject liquidity via its operations then the floor on money market rates remains low.

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