If European Central Bank President Mario Draghi gets his way today, the ECB will announce further easing to monetary policy after today’s Governing Council meeting. There was widespread malcontent in the market at the seemingly inadequate easing measures and Draghi’s “Super Mario” reputation was questioned. Since then Draghi has used his official appearances to hint that further easing measures could be coming in the March meeting noting that the Governing Council would “review and possibly reconsider” monetary policy. However the big question after the December disappointment is whether the markets will be disappointed again. “Once bitten twice shy?” It seems the expectations are still quite high ahead of the ECB monetary policy.
Why is further easing necessary?
The Eurozone economic recovery has taken a turn for the worse in the months since the last bout of easing measures. Economic growth for Q4 2015 may have come in ahead of expectations but remained a lackluster +0.3%, whilst the forward looking PMIs suggest the recovery is losing traction. Furthermore, the Eurozone unexpectedly fell back into deflation last month. Here are a few reasons why further easing is likely:
- Eurozone GDP growth remains disappointingly weak at just +0.3% for Q4 2015. This comes with Italy stagnating and Greece falling back into recession. The latter could also be another problem looking on the medium term horizon, with Greece once again struggling in its bailout program (but that one is for another day…).
- Eurozone Composite PMI fell to 53.0 which is a 12 month low in February. Although this is a positive number, it does not bode well for growth moving forward, especially with the manufacturing component falling back to a somewhat stagnant 51.2.
- Eurozone Industrial Production in December 2015 fell to -1.3% for the year which was well below the +0.8% expected. This was the first time since November 2014 that industrial production had turned negative, whilst also this was the lowest reading since August 2013.
- Eurozone inflation dropped to -0.2% in February. This was worse than the 0.0% expected by the market, and after all the monetary easing that has been thrown at the problem, the Eurozone still cannot generate sustainable inflation.
- Eurozone credit growth still needs a boost. Loans to households stalled at 1.4% in January, whilst lending to firms grew by just 0.3% in December (slower than the +0.7% growth in November)
What measures could be announced?
The ECB announcement will come in two stages, with the interest rates released at 1245GMT, before the unconventional measures (such as additional quantitative easing or Long Term Refinancing Operations) will be announced later in the press conference. Taking the December meeting for example, the market disappointment was two-fold coming initially at 1245GMT with the underwhelming deposit rate cut, and then again at 1330GMT when Draghi did not announce a QE extension. But what are the options this time around?
1) A cut to the negative deposit rate. Currently standing at -0.30% after a third 10 basis points cut in December, the analyst community consensus seems to expect another 10 basis point cut to -0.40%. There could also be a multi-tiered system introduced to the deposit rate. Other countries that have introduced negative deposit rates (such as Japan, Switzerland and Sweden ) have got a tiered deposit rate system, where banks do not pay to hold all of their deposits. This is the argument that the commercial banks will certainly have. The purpose of this is to encourage banks to increase lending and generate credit growth. This may also prevent the banks from pushing higher mortgage/lending rates on to their customers. 10 BASIS POINTS CUT IS HIGHLY LIKELY.
2) An increase in the monthly asset purchases in the Quantitative Easing program. The general consensus seems to be of around an extra €10bn per month of asset purchases (some are calling for possibly €20bn extra). Is this enough though? The other question is are the assets available for purchase? A €10bn per month increase would add €120bn to the existing c. €1.5trillion program that is due to end March 2017. AN EXTRA €10bn of ASSET PURCHASES IS LIKELY.
3) The ECB could expand the assets available for purchase to include possibly corporate debt, or underperforming loans, or even assets such as oil. THIS IS UNLIKELY.
4) Extending the length of the program by another 6 months to September 2017 could be possible, but seeing as this was done only back in December the chances are that the ECB would look at increasing the purchases before extending the length again. THIS IS UNLIKELY.
5) Introducing further Targeted Long Term Refinancing Operations. Something that the ECB has already done twice before. THIS IS POSSIBLE.
The problem that a dovish Draghi faces is that despite his insistence that the Governing Council is unanimous, there are clear divisions with the German Bundesbank President Jens Weidmann a thorn in his side, whilst other northern European countries also stand in the way of substantial further easing. Draghi’s reputation to do “whatever it takes” took a big hit in December. Can he deliver this time around? I am not too sure…
What could the reaction be?
The market was massively disappointed in December when the ECB cut the deposit rate by 10 basis points and extended the program by another 6 months. It was expecting 20 basis points and an increase to the asset purchases. Looking at the yield on the 2 year German Shatz the position on the deposit rate seems to be similar. Back in December the Shatz yielded -0.45% with the deposit rate at -0.2% prior to the ECB announcement, baking in a possible 20 basis points. The fact that the Shatz immediately rallied to -0.30% (the New Deposit rate) shows the disappointment. Now the Shatz is yielding -0.55% which is a similar differential to the deposit rate sitting at -0.3% currently. Could the Shatz again be pricing in 20 basis points and be primed for disappointment?
The other disappointment in December came with the lack of increase to QE purchases. The market still seems to be addicted to QE. My feeling is that anything less than €20bn could be taken as a fairly underwhelming move. The slow and steady approach to monetary easing does not seem to be working. There needs to be a shock and awe move to impress the market now.
Impact on the markets
In December the euro was trading at $.0550 prior to the ECB announcement. It subsequently rallied to $1.0980 on the disappointment as the euro strengthened. This time around the euro is trading closer to the $1.1000 mark, so the market seems to be set up more neutrally. Despite this though the Eurozone needs something special to gain some serious traction in an economic recovery and avoid this being just another round of easing measures that actually achieves very little. Volatility will be certain as the market tries to work out exactly what has been priced in.
The longer term chart suggests that the euro is neutral in the range $1.0800/$1.1050. These two levels should be watched for the key breakout and direction in the weeks ahead.
The European equities are also going to react with volatility. The DAX reacted sharply negatively in December to the disappointment. A strengthening of the euro (on a disappointment today) would again be negative for the DAX, especially if the disappointment comes with an underwhelming increase in QE purchases.