ECB to be sidelined for now

ECB to keep wait-and-see attitude as..

…the inflation outlook has not changed materially and as ..

…the recovery has gained some momentum..

No compelling reason to take additional liquidity enhancing measures either as…

Tensions on money market are transitory and technical in nature

Draghi to sound dovish and keep all option open, also due to ongoing strength euro

In April, the ECB kept its policy, as expected, unchanged. ECB president Mario Draghi struck a tone though that was subtly more dovish than in March and was correctly, we think, considered as a re‐opening of the door to a possible further policy easing. His comments contained substantial “verbal” easing. He stressed the risks of a “too prolonged period of low inflation” and spoke about the “rich and ample” discussion the Governing Council had undertaken on the possible need for policy easing. He suggested that the ECB was not out of room on rate cuts, but highlighted the potential to use unconventional tools, including the commitment to use QE, on which the ECB was now “unanimous”. Finally, he told the FX rate is increasingly important and sounded concerned about the strong euro. In short, Mr Draghi put markets on alert for a further policy easing. This means there is some possibility of action as early as this week. On balance,we don’t expect the ECB to take major action when it meets on Thursday. However, we think the ECB is moving – or being forced closer to additional easing. We explain why recent developments in relation to three ‘contingencies’ may oblige the ECB to take further action, but not this week.

Forward guidance in detail

In a speech in late April, Mr. Draghi elaborated on three possible contingencies that may trigger an ECB reaction. He also described the tools the ECB might use in case of each of these contingencies.

Tensions money markets

The first contingency is an unwarranted tightening of policy. Such tightening could come from three sources.
Most commented are “tensions in the short term money markets” to the extent that these are propagated to the medium term rates, in the context of receding excess liquidity. Since the April meeting there have been some tensions in the money market. Banks paid back substantial amounts of LTRO loans and asked less than usual liquidity at the regular liquidity tenders. Together with some other factors, it pushed excess liquidity to below €90B, causing eonia to spike to 0.46%. However, there was no contagion to longer tenors on the money market curve . 1‐, 3‐ and 12‐month eonia swaps never traded above 0.25% (refi‐rate). Longer tenors trade below the shorter ones, suggesting even lower eonia rates in the future. At last week’s ECB tenders, banks asked again more liquidity, offered less liquidity at the ECB absorbing tender and paid back less LTRO loans. As a consequence, excess liquidity jumped to well above €150B and eonia dropped like a stone to only 0.126%. So, we don’t think the volatility in shorter rates in the past month meets the ECB criterion to act, this is partly because markets expect the ECB to take offsetting action. As such, it highlights potential future risks in this area. As a result, we still think that at some point the ECB may come up with additional measures.

Contagion from higher US yields

Second source of the unwarranted tightening may be due to developments in global bond markets that spill over to the euro curve. This was not the case. Long term yields continued to fall in the past month, making financial conditions even easier. Also the swap spread with the US is no source of concern (at a high 100 basis points in the 10‐year tenor). However, while that means this particular ‘contingency’ is not in place this development may also be signalling possible market concerns about downside risks to the outlook for global growth and inflation.

Euro strength

The third source of unwarranted tightening alluded to by Mr Draghi is a “continued appreciation of the exchange rate”. This remains certainly an important concern for the ECB, as it threatens to push inflation still lower and to strangle the recovery. However. Also here, FX movements were limited since the previous meeting when EUR/USD traded at 1.3770 versus 1.3920 today.
The situation of the more relevant trade weighted euro is similar.

So, on these three conditions, the case for acting this week is far from clear‐cut even if there are grounds to believe that pressure for action is continuing. In the late April speech, Mr Draghi also described what form the policy response to eventually address these sources of unwarranted tightening of policy could take. He signalled that a lowering of the interest rate corridor, including a negative deposit rate, extension of the fixed rate/full allotment tender procedure beyond mid‐2015 and new liquidity injections including LTRO’s were all measures that the ECB could implement in the event of an unwarranted tightening of policy.

Transmission mechanism clogged

The second contingency that Mr Draghi indicated would merit policy action is a further impairment in the transmission of the ECB stance via the bank lending channel. The ECB’s assessment is that lending conditions are improving given the reduction of the bank funding costs and ongoing clean‐up of the banking sector through the AQR comprehensive assessment. Therefore, Draghi said that risks this contingency will materialise were very small.

Looking to recent developments, the evidence is a bit more mixed than Mr Draghi’s comments might suggest. The M3 money supply and lending data for March remained very weak. M3 money supply growth declined to 1.1% Y/Y from 1.3% Y/Y in February, matching the cyclical lows. At the same time, bank loans for the private sector failed to improve. This might be considered as going towards fulfilling the second contingency.
However, the ECB bank lending survey showed indeed some limited signs of improving overall lending conditions (first easing since 2007), but still tight conditions for SME loans. Banks reported also an increase in demand for credit. So, overall we don’t see sufficient reason for the ECB to act on this contingency at present. In any event, the main tool to address it, an ABS purchase programme is not operationally yet. It is very likely that such a programme will be introduced later this year. Another possible tool put forward by Draghi are LTRO’s targeted towards encouraging bank lending (“lending for funding”?).

Worsening MT inflation outlook

The third contingency cited by Mr Draghi is a worsening of the medium term inflation outlook. Draghi specified that this could be due to broad‐based weakening of aggregate demand or a positive supply shock that leads to a de‐anchoring of inflation expectations. Importantly, and in contrast to the policy response to the other two contingencies,, the ECB would in this case act to increase the degree of monetary accommodation, instead of simply attempting to defend the current degree of accommodation.

Looking to the developments since the past meeting, economic data have been encouraging. They also mostly exceeded market expectations. PMI business sentiment improved substantially in April and at 54 (composite) is at the highest level since mid‐2011. The progress comprised also the peripheral countries. The Unemployment rate (11.8%) is still very high, but well off its peak (12%). The better economic data were also confirmed by the national data of Germany, the main economy of the euro area. The developments outside the euro area were mixed with improvement in the US economy, but ongoing uncertainties in the Chinese one.

The inflation data showed an increase to 0.7% Y/Y in April from 0.5% Y/Y in March, while core inflation jumped to 1% Y/Y from 0.7% Y/Y previously. While this was slightly below consensus for the headline measure, it reversed most of March surprise fall. As widely commented, the monthly wiggles during March and April were partially due to the timing of Easter. Inflation remains very (too) low, but there was no worsening of the medium term inflation outlook, which was already very low. ECB (March) staff forecasts pinned inflation at 1% in 2014 and 1.3% in 2015. These might be slightly revised lower in the June ECB staff projections. Inflation expectations have changed too little in the past month to qualify them now as de‐anchored (see graph).

The rebound in inflation in April combined with stronger eco data suggest that the ECB will take time to address the inflation situation. In June they get new staff inflation forecast and in the next months, the volatility in inflation due to the Easter timing may disappear. This will allow a better judgement on the risk of deflation or on too low inflation for too long. Mr. Draghi said that this contingencies, if needed, should be dealt with by a broad‐based asset purchase programme as the limited margin that remains over short‐term interest rates wouldn’t be sufficient. This is a big step that the ECB hopes it will not be need to take.

No ECB action now

Concluding, we don’t expect the ECB to take major decisions at this week’s meeting. Some technical measures are never excluded, but also unlikely to be taken now. At the press conference, we think Mr. Draghi will keep a generally dovish bias but how far he will go is not entirely clear. This is likely to be the key focus for markets. According to Bloomberg, only 2 out of 58 analysts are looking for a refi rate cut. We think that market prices discount still some residual risk of a policy change. So, there might be a small negative market reaction (higher rates/yields) if policy is left unchanged, but the comments of Draghi particularly any indications as to how close or how far we might be from QE should determine the scale and direction of market reaction.