If you had looked at the EURUSD rate first thing this morning and then compared it with the rate as we approached the end of the European session, it was pretty flat, give or take a few basis points. However, the calm hides a huge amount of volatility in the single currency and a dramatic step into the unknown from the ECB.
After ECB President Draghi telegraphed the bank’s desire to target low inflation at last month’s meeting, there was little the Bank could do but act at this meeting. From an ECB stand point the Bank has thrown the kitchen sink at deflation and the new actions it has taken includes:
- Interest rate cuts: the benchmark rate was cut by 10 basis points, the marginal lending rate was cut by a larger than expected 35 basis points, and deposit rates were cut by ten basis points, which is the first time that this rate has been in negative territory.
- Lending: the bank brought back LTRO, although this time it will be known as the targeted longer-term refinancing operation (TLTRO). This is to stimulate lending to the private sector, and measures have been taken to ensure banks don’t just use the money to buy government debt. The amount of money available for TLTROs is EUR400 billion, and maturities are for four years.
- The bank embarked on preparatory work to purchase asset-backed securities in the market, another incentive to get banks to lend.
- Lastly, the bank has suspended its policy to sterilise the liquidity injected under the Securities Markets Programme, which is the equivalent of approx. EUR 170billion extra liquidity in the system.
One measure is conspicuous by its absence – QE. Although Draghi did not rule out the prospect of QE, it doesn’t seem like it is around the corner, hence the market seemed under-whelmed by the new steps taken by the ECB today. Stocks gave back early gains, and after initially falling, EURUSD eventually rallied back to an intra-day high of 1.3650, before settling around 1.3610.
ECB action irks Germany
Draghi may have taken a radical step by ECB standards, but it is likely that the cut to the deposit rate did not come without a fight. Already the German banking lobby group is complaining about the rate cuts saying that they will hurt savers. The Association of Private Banks said that a negative deposit rate is unlikely to lead to a pick-up in lending, as over-indebted companies in Europe’s periphery don’t want to borrow in this environment. It also argued that a negative deposit rate in Denmark in July 2012 did not boost lending. Interestingly, Draghi said that the decision to cut rates was unanimous; however, if the Bundesbank gets flack at home for this decision then we doubt it will vote for further loosening down the line.
Will negative deposit rates actually work?
The Bundesbank isn’t the only one doubting the ability of negative deposit rates to boost lending. Open Europe, a pro-European, pro-reform think tank, said that it is not clear that negative deposit rates or more LTROs will be successful. It argues that ECB surveys already show that demand for loans is weak, added to this banks continue to de-leverage ahead of ECB stress tests due later this year. It also argued that bank lending remains fragmented, with banks in the core not willing to lend and invest in the periphery. Even with negative deposit rates, it is not clear, due to the above factors, that yield in the periphery will tempt more lending to take place. Added to this, the dramatic tightening in peripheral yield spreads in the last 12 months could actually make lending less attractive in this environment.
Don’t expect further ECB action
Draghi appeared to take note of German reluctance to cut rates further, when he said that interest rates have reached their lower bound. This is important for EURUSD traders since a negative rate of 10 basis points is unlikely to lead to a wave of EUR hitting the economy. For that to happen rates would have to be cut to -3% or -4%, if that is not on the horizon then 1.3539, the low from 1330 BST today, could be a medium-term bottom for this pair.
After one month of waiting for action from the ECB, we don’t think this is the start of a prolonged cycle of easing. The bank will want to see the TLTROs get taken up by banks, after that it could take many months before that money starts to hit the real economy. This still leaves the problem of weak inflation. Even if prices continue to decline we think that the ECB could refrain from acting, saying that it is waiting to see the impact of TLTROs, potentially for the rest of this year. Where does that leave the EUR? If the USD fails to rally then we could see further upside, and future weakness in EURUSD could be dependent on a stronger USD.
A sliver of good news to keep the bulls alive
There was some good news from the Eurozone today, Moody’s, the credit rating agency, said that financial fragmentation in the currency bloc had fallen to its lowest level since 2011. This rating looks at economic indicators, government bond yields and cross-border lending. While there have been positive developments in economic data and bond yields, cross boarder lending remains weak and this index still has some way to go before it is back to pre-crisis levels.
Overall, Draghi didn’t disappoint and he threw the kitchen sink at the problem, the trouble is that his kitchen sink is smaller than other central banks’. We think that the ECB has plateaued here, but if we are wrong, then the next step is QE.
The currency impact:
As you can see in the chart below, EUR swap rates (Eonia rates), that are based on ECB interest rates, have fallen sharply, and where they go EURUSD tends to follow. Thus, if the ECB stops here and doesn’t cut rates further then we could see this rate start to base, which could protect EURUSD downside.
Figure 1:
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