The January ECB meeting will bring no important developments. The ECB will stay active in terms of the SMP, without changing its intervention strategy provided no dramatic event for the stability of the euro system takes place. Any announcement of non-conventional measures seems unlikely before the second thee-year fund auction due at the end of February. Official rates may drop below 1.0% if “substantial downside risks” on growth estimates (0.3%) should materialise, but a cut is unlikely this month, in our view…..
On hold after the December measures…
The 36-month operation carried out in December triggered a surge in excess liquidity, to EUR 483Bn (22 Dec. 2011), which then eased in part to EUR 413Bn (08 Jan. 2012). Excess liquidity led in turn to a significantly stronger recourse to the deposit facility, up to EUR 481Bn on 10 Jan. 2012, although this does not mean that the operation had not impact on financial conditions in the euro area. In addition to compressing money market rates, that will continue to drop, more importantly the ECB has eliminated refinancing risk for European banks this year, and cooled cost of funding, with much stronger implications on the cost and availability of credit than would have been the case for an official interest rate cut.
The announcement of further 36-month operations by the ECB in 2012 cannot be ruled out, and the purchase of covered bonds may also, or alternatively, be stepped up. In order to tackle a potential lack of guarantees, the ECB could further slacken criteria on viable security, admitting also assets with ratings lower than A- and/or accept unsecured bank loans. However, we believe the ECB will at least await the outcome of the auction on 28 February, before adopting any further non-conventional measures.
… which may also indirectly improve refinancing conditions for governments
Indirectly, the measures put in place by the ECB have also eased pressures on government bonds, aiding in particular a sharp drop in short-term yields in Italy and Spain. Additional benefits could come with the next 3-year auction on 28 February, especially if banks further increase their exposure to the government bonds of peripheral countries, taking advantage of carry trade opportunities offered by the market.
ECB to remain active on SMP, but no change expected in terms of action “strategy” and communication
The ECB will continue to use the SMP, although along the same lines as in the past four months and more intensively in the run up to the refinancing auctions (the drop in purchases over the past three weeks is explained by a less intense calendar of issues compared to the previous months). However, we stick to our view that the ECB will not implement an actual round of QE, barring a dramatic turn of events that would risk entirely compromising monetary policy transmission and the stability of the euro system. The reasons for this are still ideological, regardless of the fact that a structured purchase program, transparently announced, would have more or less the same effect on the ECB’s balance sheet, while boosting confidence to a much greater extent. An explicit communication from the ECB would be enough to dissipate doubts over the financing capacity of Italy and Spain.
There is a possibility that the ECB may be forced to act more pervasively in support of government bonds, in case of tensions leading up to the refinancing auctions to be launched by Italy and Spain in the next three months, given in particular the obstacles still hindering the EFSF II’s financing capacity, especially in the event of a downgrading of France and Austria, or even worse a widespread rating downgrading by S&P that could be announced in March1 if no steps forward are made on the front of EFSF II and of the new fiscal contract at the Summit scheduled at the end of this month.
Rates below 1.0% in H1 2012
The ECB is likely to cut interest rates again, bringing them below the critical 1.0% threshold. In December, the ECB observed that there were still “substantial downside risks” weighing on the macroeconomic scenario, despite the strong downgrading of growth estimates for 2012 (the November press release only mentioned “downside risks”). The risks mentioned stem from tensions on the financial markets, and from possible repercussion on the real economy. Also, a further element of risk is a potentially weaker overall picture than forecast (a new element compared to the November release). By contrast, in December the ECB assessed the risks weighing on the consumer price trend as balanced. Therefore, our impression is that the ECB is still not entirely ruling out further cuts to interest rates to below 1.0%. During his latest press conference, Draghi said that the interest rate path also depends on fiscal policy developments.
Therefore, the hope is that in the presence of strict austerity measures almost throughout the euro area, the ECB may opt for a slackening and cut rates below 1.0%. However, the first move in this direction is unlikely to come already in January, as at the December press conference Draghi indicated that the cut was not a unanimous decision, and that some members of the Council disagreed on its timing. The ECB may cut rates to 0.5% by May/June, although it could also stop at 0.75%, considering that a further 0.25% cut would not necessarily make a difference. With the refi rat at 0.75% and an equivalent curt of the rate on deposits, on the other hand, the Eonia would in any case drop to zero: as a result of full allocation, the overnight rate remains compressed in the low end of the official rate corridor.
Even if the ECB does not cut rates to less than 1.0%, we believe it is highly unlikely to set out on a monetary policy normalisation path before the end of 2013 or early 2014. In the best of cases, growth will rise back to levels just in line with the potential rate in 2013, as financial crises tend to have rather persistent effects on savings and investment trends. In such a context, the output gap is expected to stay markedly negative, and should help keep under control tensions on costs, wages, and prices. Indeed, the ECB is forecasting inflation at 1.6% in 2013.
In conclusion: the measures adopted to support banks and the banking system are of unprecedented scope, and the ECB is therefore unlikely to take further steps in the immediate term. Nor do we expect dramatic changes in communication from Frankfurt on the SMP, barring truly catastrophic events. The ECB may cut rates to below the 1.0% threshold in the first half of 2012 to prevent the materialisation of the aforementioned “substantial downside risks” on what is already a very fragile growth scenario.
(1) On 5 Dec. 2011 S&P placed under credit watch all the euro area countries. This implies a 50% chance of a downgrade within three months. The reasoning behind the move was essentially political, as the agency indicated that the euro area’s financial stability was placed at risk by persisting “disagreements” among the public authorities on how to solve the debt crisis.
Appendix
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