- The ECB abstained from easing today but Draghi was very dovish and said “the Governing Council is comfortable with acting in June”. Hence we expect both a deposit and refi rate cut of 10bp in June.
- According to Draghi the decision in June depends on the outcome of the new projections. We think it is almost certain the ECB will lower its 2014 inflation projection and it could be lowered from 1.0% to 0.8%. We think this will lead to easing as Draghi said, “there is discomfort in inflation projections”.
- Generally Draghi had a more dovish tone related to ECB’s view on inflation as he added the ECB expects “only” a gradual improvement in inflation. Moreover, he said the ECB will not just resign itself in accepting low inflation as a fact of nature.
- Although there has been an improvement in the growth outlook Draghi sounded dovish and repeated that the ECB continues to see risks to economic outlook on the downside. Regarding the signs of improvement in labour markets he reiterated that “unutilized capacity is sizeable”.
- The ECB discussed all instruments today, but when asked about rate cuts the answer was that a lowering of the corridor would have more impact. Hence we expect the ECB to cut both the refi and deposit rate at the meeting in June.
- The communication today supports our view that the ECB will cut rates before introducing a broad-based QE programme. Draghi has previously said a worsening of the medium-term outlook for inflation will require “to increase meaningfully the degree of monetary accommodation”. However we do not think the ECB is ready for this next month.
- In our view a negative deposit rate to drive down yields on shorter maturity bonds. This should follow as negative rates imply a higher cost from holding deposits at the ECB, causing an intensified search for positive yields among investors. The search for alternatives could among other things help reduce fragmentation, as strong banks would be given more incentive to lend to weaker banks. The mechanism behind this can be explained as the ‘hot potato’ that is passed around banks with no one wanting to be the one getting burned. For more on the implications of a negative deposit rate and the Danish experience, see More easing from the ECB: We expect a negative deposit rate.
- A negative deposit rate will also be an effective tool to cope with the strengthening of the exchange rate. This should follow as it opens up possible outcome for rates to the downside and thus via downward pressure on the short end of the EUR money market curve foster significant EUR downside.
Market reaction
- The markets rallied massively on Draghi’s remarks on the ECB being comfortable with acting on the June meeting. These words completely turned around the disappointment from an unchanged statement and 1y 1y Eonia declined to 16bp (down from 23bp). This has left the 1m EONIA forward curve flat around 10-12bp from the June Maintenance Period and into most of 2015 – hence the market has more or less fully priced a 10bp rate cut. Peripheral bonds also tightened to Germany on this wording but the effect was not as significant than the movements in the short end. This tells us that the market is putting a higher likelihood of a rate cut than some form of QE program as the (promised) the action in June.
Danske Bank