ECB: “We feel comfortable with acting next time”

Soft words, no cuts this time – as expected. But judging from what Draghi said, we feel that the probability for action at the next meeting is now above 50%. We change our forecast for June and expect a cut in the main refi rate by 10 basis points and also consider a cut in the deposit rate by the same magnitude as likely. We still do not expect QE to happen.

Mario Draghi did not exactly announce new measures but in our view, he gave a hint. Elaborating on the strong euro and the subdued inflation outlook, he said, “we are comfortable with acting next time” but we are waiting for more information, alluding to the new staff projections that will be published in early June. The ECB staff will very likely take down the 2014 projection (currently 1%) but probably also the projections for 2015 (1.3%) and 2016 (1.5%).

Besides the strong euro, tensions on the money markets and weak bank lending continue to be a concern. We consider a QE programme less likely than a conditional LTRO to support lending especially to SMEs, a kind of “funding for lending” programme.

Market – Agrees to disagree

Subdued initial response to the ECB rate announcement in the market with a kneejerk marginal strengthening of the EURUSD and (connected) a boost in e.g. 1M Eonia swaps to 22bps. High volatility in short Eonia swaps (and the fixing) is a new normal with excess liquidity often below €100bn. These moves spiked when Draghi adamantly talked about independence and credibility regarding the “too strong” Euro. This pulled 1M Eonia close to the refi and EURUSD very very close to 1.40 (only to fall back strongly a bit later).

Note that the 1M swap roughly spans the time to the next ECB meeting, and at 24bps, both a high level and a lot of volatility is implied in the Eonia fixing over the coming month.

De-anchoring of medium term inflation expectations – that hasn’t happened according to Draghi, but this is a subjective matter indeed. For instance, for Q1 2016 the ECB still works with a 1.7% forecast, but the market implied number (from HICPxT inflation swap market – so different indices) is almost 50bps below that. That’s a lot by any measure, and with the recent downward revision from the EU for near-term inflation, the tendency looks to be for converging a bit towards the market.

Inflation swaps have today corrected downwards modestly. However, Draghi’s contingency comments link (1) the coming staff projections on inflation (early June) and (2) prospective easing quite firmly. Referring to the distance between the ECB and market given above, we find such a revision quite likely and perhaps even necessary, and with the contingency mechanism given, the odds of summer easing are suddenly up substantially. This is particularly the case if the coming prints disappoint even slightly. The nominal swap market reacted to this and 10Y moved below 1.70% and 2Y Euribor based swaps hit the lowest level since February.

Trade wise, positioning for ECB easing with limited downside is best done in the EURUSD xCcy basis swap market. Here the curve is immensely flat and tight historically, and receiving 1Y1Y can be entered at around -1bp. Easing by the ECB should widen the basis, and at current levels the risk/reward is excellent.