ECB Preview

The ECB meets Thursday and is widely expected to deliver a package of easing measures.  Here, we preview some of the possible actions as well as implications for the euro and other risk assets.

RECENT DEVELOPMENTS

ECB officials have been pushing back against the need for aggressive easing, particularly restarting Quantitative Easing (QE).  Central bankers from Germany, France, and the Netherlands all expressed opposition to QE last week.  While we believe the program will be restarted, there is a chance that it will not be announced until a later meeting.

WIRP suggests 100% odds of a rate cut tomorrow, with 37% odds of a 20 bp move.  There will most likely be a change in the forward guidance, which currently sees rates at or below current levels at least through H1 2020.  The language may drop any reference to a specific date, leaving policy open-ended.  The new 2-year TLTRO will be launched.

We need to make a distinction between the main ECB policy rates.  The main refi rate is the interest rate that commercial banks pay to borrow from the ECB.  The deposit facility rate is the rate that banks receive to make overnight deposits of their excess reserves at the ECB.  Because it is currently at -0.4%, banks now pay to make these deposits.

Negative rates come at a cost.  Studies suggest eurozone banks are incurring losses of -EUR7 bln per annum due to negative rates, and that Return on Equity (ROE) is about 40 bp lower as a result.  Banks have passed on some of these costs to corporate and institutional clients, but not yet to retail clients.  The ECB has downplayed these costs, which Executive Board member Coeure called it “peanuts.”  Banks might disagree.

There is talk of tiering, which would allow commercial banks that have excess cash to avoid paying the entire negative depo rate.  Tiering would charge different negative rates on different amounts deposited at the ECB.  Or perhaps tiering would exempt them from negative rates up to a certain threshold.  The fact that tiering is being discussed acknowledges that negative rates do pose recognizable costs to eurozone commercial banks.

This begs the question of whether negative rates work at all.  The academic literature is still developing, but it’s worth noting that one piece suggests negative rates inhibit lending.  Eurozone household credit rose 3.2% y/y in July, which is languishing near cycle lows.  Similarly, loans to non-financial corporations rose only 3.3% y/y in July, also near the lows.  Elsewhere, M3 rose 5.2% y/y and has picked up noticeably from 3.7% y/y in January.  Another STUDY suggested that negative rates in Japan lowered inflation expectations.

IMF Managing Director Christine Lagarde takes over for Draghi on November 1.  While she does not have a central banking background, she brings a wealth of experience in crisis management.  Indeed, she worked closely with Draghi during the eurozone crisis, crafting aid packages for Greece, Ireland, Spain, and Portugal.  We expect her to take a similarly aggressive approach to future policy as Draghi would.

A BRIEF HISTORY LESSON

ECB President Jean-Claude Trichet hiked rates 225 bp from December 2005 through July 2008.  The main refinancing rate peaked at 4.25% but once the Great Financial Crisis hit, Trichet quickly cut rates.  Starting in October 2008 with a 50 bp cut, the ECB quickly took the policy rate down to 1.0% by May 2009.  It stayed there until Trichet started tightening with an ill-conceived 25 bp hike in April 2011, followed by a second hike in July 2011.

Mario Draghi succeed Jean-Claude Trichet as ECB President in November 2011.  He was endorsed by German newspaper Bild as “the most German of all remaining candidates.”  Little did Bild know just how un-German Mr. Draghi would turn out to be, as he promptly reversed Trichet’s two final hikes with cuts at his first two meetings on November and December 2011.

With the eurozone crisis in full bloom, Draghi had to be even more aggressive.  He will best be remembered for his July 2012 pledge to “do whatever it takes to preserve the euro” and it wasn’t just rate cuts.  In September 2012, the ECB started its Outright Monetary Transactions where it bought sovereign bonds.  In July 2013, Draghi introduced forward guidance on interest rates as part of the ECB’s policy stance.

As the economic malaise deepened, the ECB continued to cut rates.  The ECB cut the main refi rate 25 bp in July 2012, May 2013, and November 2013 which took the main refi rate to 0.25%.    The depo rate was cut to 0% in July 2012 and kept steady even as the main refi rate was cut further in May and November 2013.  When the ECB cut the refi rate 10 bp to 0.15% in June 2014, the depo rate was cut 10 bp to -0.1%.  The ECB cut both rates 10 bp in September 2014 to 0.05% and -0.2%, respectively.  These rates were tweaked several times until both settled at the current rates of 0% and -0.4% in March 2016, respectively.

In January 2015, the ECB announced it would undertake Quantitative Easing (QE).  QE began at the March 2015 meeting at a pace EUR60 bln in purchases per month and peaked at EUR80 bln per month in 2016.  Tapering of QE began in April 2017 with purchases falling to EUR60 bln per month and continued in January 2018 when it cut its monthly purchases in half to EUR30 bln.  In June 2018, the ECB announced it would lower its monthly purchases to EUR15 bln in Q4 2018 before ending altogether in December.  And that’s where we stand now, with the ECB’s balance sheet at around EUR4.7 trln ($5.14 trln) in August.

ECONOMIC OUTLOOK

The economy continues to slow.  The IMF expects GDP growth of 1.2% this year and 1.4% next year, down from 1.9% in 2018.  GDP growth slowed to 1.0% y/y in Q2, and so we see downside risks to the forecasts.  Much of this Q2 weakness is being driven by Germany, where growth slowed to 0.4% y/y from 0.9% in Q1.  French growth picked up to 1.4% y/y from 1.3% in Q1, while Spanish growth only slowed to 2.2% y/y from 2.3% in Q1.  Italy is the other weak spot, with GDP contracting -0.1% y/y in both Q1 and Q2.

Inflation continues to fall.  Headline CPI rose 1.0% y/y in July and August, the lowest since November 2016 and half the 2% target.  Core inflation is even lower, rising 0.9% y/y in July and August.  Manufacturing PPI rose 0.3% y/y in June and July, the lowest since October 2016 and suggesting little in the way of pipeline price pressures.  Inflation expectations remain too low.

The external accounts are in good shape.  The IMF forecasts the current account surplus remaining steady at 2.4% of GDP this year and next.  Of the four largest eurozone economies, Germany runs the biggest surplus (forecast at 7% of GDP this year), followed by Italy (3%) and Spain (1%).  France runs a small deficit equal to around -0.5% of GDP.

INVESTMENT OUTLOOK

Over the past 13 ECB decision days dating back to the start of 2018, the euro has finished lower in 9 of them.  The last three meetings on April 10, June 6, and July 25 all saw the euro finish firmer, though the April and June gains were both less than 0.1%.  Looking at other asset classes, the behavior on ECB meeting days is much more mixed.  STOXX Europe 600 was down in 6 of the past 13 meetings, EURO STOXX Banks was down 6 of the past 13, MSCI EM was down in 5 of the past 13, and MSCI EM FX was down in 6 of the past 13.

With the ECB widely expected to deliver a dovish package Thursday, we may see some “sell the rumor, buy the fact” price action for the euro.  Yet Draghi is likely to push back against any euro strength.  With the impact of negative rates on the economy unsubstantiated, a weaker euro is the easiest way to get some stimulus to the economy.

Ahead of the decision, the euro is trading at the lowest level since September 4.  Break below $1.0985 is needed to set up a test of the September 3 low near $1.0920.  After that, charts point to a test of the May 2017 low near $1.0840.  Break below that would set up a test of the April low near $1.0570 and the February low near $1.0495.

We remain bullish on the dollar due to our underlying optimism regarding the US economy.  Interest rate differentials and monetary policy divergences still favor the dollar, at least for now.  Again, we stress that Fed rate cuts should not be viewed as a done deal.  It is data-dependent.  Yet despite the market’s uber-dovish take on the Fed, the dollar has held up well so far.

What’s also driving our ongoing dollar bullishness is that as dovish as the Fed has shifted, other major central banks have also shifted in the same manner, if not more so.  Besides the ECB, the BOJ is expected to add stimulus before year-end.  RBA and RBNZ are already cutting rates, with the BOC likely joining them by year-end.  In EM, many have already started easing.  Those that haven’t are likely to start in the coming months.