Last Thursday, the ECB lowered its main refinancing rate by 25bp to 0.25% and its rate on the marginal lending facility by 25bp to 0.75%. It left the rate on its deposit facility unchanged at 0%. The main driver for the rate cut was the negative inflation surprise in October when both headline and core annual inflation for the euro area dropped below 1% (to 0.7% and 0.8%, respectively). The Governing Council left its forward guidance unchanged, ie, with a downward bias, by stating that “it continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time.”
In the press conference, President Draghi revealed that all Governing Council members saw the need to respond to the mounting disinflationary pressure but the timing and decision to cut last Thursday was not unanimous. Some Council members would have preferred to wait for more details on the October inflation surprise and the November data but apparently those on the ECB’s Governing Council that had been calling for a cut since the summer gained the upper hand.
President Draghi also mentioned in the press conference that he did not expect annual inflation to bounce back in November and all expected a rather protracted period of low inflation. President Draghi highlighted the drop in October inflation was broad-based and not only due to lower food and energy prices but also reflected lower service and other goods price inflation Against this background, we expect the ECB to lower its 2014 inflation forecast, currently at 1.3%, and present a very subdued outlook for 2015 as well (to be included for the first time in the December quarterly ECB forecast).
The ECB decided to extend its fixed-rate, full-allotment facility through mid-2015for all operations, which makes another very long-term operation (VLTRO) less urgent. With the extension of the full-allotment procedure for the 3m LTROs, the prospect of a liquidity cliff following the end of the three-year LTRO has been addressed, and we think that the launch of another VLTRO has become less imminent. However, we think that the risk of seeing the ongoing economic recovery founder on a credit constraint due to the unwillingness of banks to expand their holdings of risky assets at the time of the banks’ “comprehensive assessment” remains high. The ECB, together with the EIB and the EC, will have to address that issue at the beginning of 2014 to avoid a credit crunch in peripheral countries, including possibly modifying its collateral requirements again.
We don’t expect more determined action in the shape of another cut in rates and a negative deposit rate, VLTROs or even talk of QE (see Euro Themes: The spectre of deflation, 24 September 2013) in the coming months but if inflation and expectations fall further, the ECB may have to act forcefully again next year, especially if the Fed starts tapering and the EUR front-end rates come under sell-off pressure.
Liquidity conditions, market reaction and outlook
Unsurprisingly, euro rates rallied across the curve following the ECB cut, which was not priced in for this week. The largest moves occurred at the 2-3y horizon (end 2015-16), at which EONIA forwards rallied around 15bp, while at the 1y horizon rates rallied around 10bp. The EONIA forward curve is now showing EONIA staying in the 10-15bp range over the next year and moving to around the 25bp refi rate in mid-2015. Given that by mid-2014, it is highly likely that the liquidity surplus will be below €100bn (in our view, it will move below that level sooner, possibly even before year-end) and will therefore exert upward pressure on EONIA (even if small), the stable pricing of EONIA forwards suggest that the market is expecting some kind of liquidity action by the ECB (in H1 14), beyond what was announced last Thursday.