ECB Preview: Draghi Sees Signs of Improvement

• We expect Mario Draghi to sound slightly more optimistic at this month's Governing Council meeting. It almost seems like a foregone conclusion that policy rates will be on hold.
• Since last month's meeting, there have been tentative signs that soft data has begun to improve, peripheral spreads have tightened further and money growth has picked up speed.
• We expect a gradual economic recovery in 2013 and thus the ECB could be on hold for a very long time.

First signs that the economy has bottomed out

Since last month's meeting, there have been tentative signs that the economy has bottomed out. Soft data has begun to improve, peripheral spreads have tightened further and money growth has picked up speed. Of uttermost importance, M1 growth increased from 5.0% in September to 6.4% in October - thus strengthening the signal of a rebound in growth on a six-month horizon. At a conference in Paris on 30 October, Draghi described the current situation as 'a relative stabilisation of market conditions, and more generally of improved confidence about the stability of the euro area'.

In such an environment, the ECB Governing Council is likely to save its ammunition for later. Some doves in the Governing Council may argue for further easing but it is hard to see how the hawks can agree with this when there is good reason to believe that the economy has bottomed and monetary developments may have fuelled renewed concerns about the inflationary risks of the already very loose monetary policy.

Overall, we do not expect any new measures and the wording may indicate that the ECB is becoming slightly more optimistic.

Further easing may eventually come in the form of an activation of the OMT programme. The announcement of the programme has, however, been so successful in bringing down sovereign spreads that the activation of the programme may never be needed. We believe that eventually some negative news from Spain (on banks, the housing market, fiscal consolidation or regional independence) may unnerve investors and we could see a mini-crisis prompting Spain to ask for help from the ESM and ECB. If not, the instrument may never be used. This would probably be one of the ECB's biggest successes.

We anticipate a gradual economic recovery in 2013 and thus the ECB could be on hold for a very long time. We expect policy rates to be unchanged until 2015 when the ECB may begin to hike rates at a measured pace.

However, there is one caveat. Excess liquidity will decline when banks have the opportunity to return liquidity from the 3Y LTROs. The first date for early repayment is 30 January 2013. Excess liquidity is currently around EUR600bn. If it drops sharply, the ECB could counter this with further easing in February or March 2013. Excess liquidity will probably have to fall well below EUR200bn before rates are pushed up.

It is not obvious what kind of easing the ECB should apply:

• Unless excess liquidity falls dramatically, a new round of LTROs
• A would probably not make much difference. Even then, banks would probably not take large amounts unless the new LTROs are made more attractive than the previous ones (longer terms or more beneficial rates).
  funding for lending programme
• may also prove to have little effect as loan demand remains weak and banks use deleveraging as one way to fulfil regulatory demands.

Reserve requirements

ECB staff projections could be further reduced or removed. This would free up to EUR100bn on banks' balance sheets. It would also have a positive impact on the real economy but it would probably be limited.
The ECB will also reveal its quarterly staff projections for growth and inflation. The staff will probably project very modest GDP growth (0.1%) in 2013 and a pick-up (1.0%) in 2014. The inflation forecast should reveal that inflation remains well-anchored, with inflation expected to come in just below 2% in both 2013 and 2014.

Market reaction

We expect a very modest market reaction. The EONIA market is pricing in almost a zero probability of a deposit rate cut at the December meeting. The ECB would not have to deliver much to surprise. Hence, just a hint that the ECB is moving towards further action is likely to be perceived positively by risk markets and lead to a further compression of EONIA rates and a bullish steepening in the 5-30 segment of the EUR swap curve. If Draghi unexpectedly delivers a rate cut or announces new LTROs, we expect to see a more pronounced steepening of the yield curve.

Annex: what's left in the toolbox?

Interest rate cuts

Interest rates are now so low that the benefits of additional rate cuts are probably limited. If the refi rate and the deposit rate are both lowered the deposit rate will move into negative territory. Cutting the deposit rate into negative territory could reduce the fragmentation of the interbank market by incentivising lending to weaker banks. However, it is difficult for banks to pass on negative deposit rates to clients and this could harm the banks' revenues. In addition, there might be technical difficulties in some systems if they have to deal with negative policy rates.

If, on the other hand, only the refinancing rate is lowered so that the spread between the deposit and refi rate is narrowed, this could negatively affect the working of the interbank market. Nevertheless, a refi rate cut could have a positive impact in the peripherals that are relying heavily on ECB funding via the LTROs. Furthermore, it would signal an easing bias that would keep rates in check.

There might not be a clear-cut conclusion when the ECB Governing Council weighs these arguments for and against further rate cuts. As a result, it will probably - at least for now - choose to apply more non-standard measures instead.

Long Term Refinancing Operations

The ECB could offer new 3Y LTROs on the same terms as the old ones or it could go a step further and offer longer terms or more beneficial rates. However, there is already plenty of liquidity around at least until early next year. In the current environment, banks would probably take very little on a new LTRO unless it is made substantially more attractive than the previous ones. And even if banks took large amounts, the impact on market pricing would be fairly limited as liquidity is already plenty.

Remove reserve requirements

The reserve requirement for banks was halved from 2% to 1% on 18 January 2012. A temporary removal of reserve requirements would free up about EUR100bn and is supportive for lending to the real economy.

Funding for Lending

The Bank of England has introduced a Funding for Lending scheme designed to boost lending to households and businesses. For such a scheme to be successful, it needs to give banks strong incentives to boost lending. The Bank of England has designed its scheme so that banks that are increasing their lending will pay the lowest fee on their borrowing while those that reduce their lending will pay a higher fee. In the euro area, the interest rate offered by the ECB would have to be very low and with a long time to maturity in order to make this instrument more attractive than existing offers. In the absence of loan demand and with many banks using deleveraging as a way to fulfil regulatory requirements, it would be difficult to boost the euro area economy using this tool in the current environment. Nevertheless, we think the likelihood of this instrument being put to use has increased as the economic outlook has deteriorated across the currency union and it is now the whole euro area which could benefit from such a stimulus. Also, the alternatives under consideration are not miracle cures either. So far, there has been no indication that the ECB will apply funding for lending.

Outright Monetary Transactions

We expect Draghi to focus on the new OMT bond buying programme. We expect him to again send a clear signal that the ECB stands ready to purchase bonds in maturities up to three years in a firm manner (in 'unlimited' amounts). We do not expect to get more details on target levels etc.

The question is whether we will actually see the ECB start buying significantly to bring rates further down when Spain asks for help. The old bond purchasing programme (SMP) had a tendency to disappoint. We think that the ECB has learned that it is vital to gain credibility from the beginning.