There are two priorities for the ECB at its meeting this week. Firstly, to take out additional insurance against disinflation as the EM crisis risks a disinflationary shock at a time when inflation is already low. This would involve a 10/15bp cut in the refi and deposit rates. Second, is to enhance the liquidity environment and hopefully reduce money market volatility by shifting toward allowing the SMP to be left unsterilized.
Since the ECB’s meeting back in November, when it surprised with a 25bp cut, the downside risks to growth are slightly reduced while deflationary risks have increased. The mfg PMI data (and likely service PMI on Wednesday) show that sentiment has not deteriorated. The ECB still worries that this growth is uneven and fragile but it is at least moving in the right direction even if the pace is a little glacial. But the ECB’s actions are dictated not by growth but by the inflation outlook as it looks to deliver on its inflation mandate.
What has changed since November is the intensification of the EM crisis that raises the prospect of a deflationary shock on the back of lower EM growth and commodity prices. This tilts things in favour of further easing from the ECB with a further 10/15bp shaved off the refi rate and a negative deposit rate as likely.
While we also see the deposit rate being cut into negative territory, this is a close call as the ECB could decide it needs to keep something in reserve to help strengthen its forward guidance. It could take a further fall in inflation to see a deposit rate cut. From a market perspective a negative deposit rate does not seem to be fully priced and we continue to favour using very OTM options on Euribor via:
1) Dec14 Euribor options with a 99.875 strike as well as,
2) March 15 mid-curve plays to capture the risk of the ECB moving before March.
While the ECB’s liquidity operations have allowed money market rates at the short-end to move lower the adjustment was not rapid and has been accompanied by increased volatility. We had been looking at the prospect that the ECB would lower the reserve requirement rate and leave the SMP unsterilized in order to enhance excess liquidity. An unsterilized SMP seems more likely now that the Bundesbank is reported to favour the idea.
While this is not QE it is a step in that direction as outright bond purchases via the SMP will no longer be liquidity neutral. An increase in excess liquidity by €175bn should help o/n EONIA trade close to zero.