Rates Spark: What to expect from the ECB

When trying to decipher market behaviour around today’s ECB meeting, it is worth distinguishing between near term ‘knee-jerk’ reaction and the longer-term trend.

Our long-term view is: rates are reflecting a protracted recovery and lasting damage to inflation. However, there is no longer a basis to reflect the same degree of market stress they did back in the spring.

This suggests to us that despite low outright rates, a normalisation of the EUR yield curve is justified. This means more upside than outright downside and a gradual re-steepening. The belly of the curve on the other hand has little room to rise if market expectations of very low inflation, preventing a policy tightening, are fulfilled.

Nearer-term, we see odds as skewed towards lower rates around today’s meeting.

The first reason has to do with macroeconomic projections. If the ECB continues to project a significant inflation shortfall compared to its target in the coming years, any display of optimism would lack credibility. This in turn could be detrimental to sentiment in our view, with markets pricing a lesser degree of central bank support, for instance by lowering the probability of a QE extension.

In short, good news can be bad news for markets, especially when it comes from a central bank.

Another factor is expectations. A Bloomberg article yesterday seemed to support Schnabel’s view that the economy has progressed roughly along the lines forecasted by the ECB in June. This hardly makes the case for more easing for the time being and we think markets are expecting a cautiously optimistic tone.

This would make any dovish display more impactful from a rates point of view.

3-month Euribor hit another all-time low yesterday at -0.493%. It is closing in on the -0.5% deposit facility rate of the ECB which should in theory serve as a floor to fixings.

That is the rate at which banks can redeposit their excess liquidity at the central bank. In practice, the overnight rate €STR and 1m Euribor are already below the deposit facility rate – banks are charging those market participants without access to the facility for redepositing at the ECB and the rising excess liquidity, now approaching €3tn, is keeping the pressure on rates.

The ECB has partially alleviated the cost that the negative rate charged on the excess liquidity puts on banks by introducing tiered deposits. Six times the minimum reserve requirement is what banks are now allowed to deposit at zero charge before the -0.5% penalty rate kicks in, but that multiplier was fixed before the latest steep increase in excess liquidity.

Increasing the multiplier could thus be a technical tweak that might be considered and it could also lessen the downward pressure on Euribor rates. However, ECB officials have not signalled any urgency on that front. Furthermore, having provided banks €1.3tn in liquidity via the last TLTRO.III at a rate as low as -1% if certain requirements are met, could be viewed as an offsetting subsidy.

That said, the inclusion of a question on the multiplier in the ECB survey of monetary analysts for today’s meeting signals at least an increased awareness of the issue.

Today should prove an eventful session with Italy and Ireland carrying out auctions in the morning, as European countries release industrial production numbers.

The US Treasury auctions 30-year bonds today.