A few notes on the ECB conference

The recent drop in Euribor rates is due to a large extent to a fall in liquidity and credit risk premiums on the back of improved market sentiment. However, in recent weeks there has also been speculation on the market that the ECB may want to narrow the spread between the rate on its marginal lending facility (MLF) and the deposit rate. Assuming a parallel corridor would involve a cut in the refi rate, which could be either 25 or 50bps. The reason the ECB may do this is to give the greedy banks even cheaper funding, but also so that they can ensure a firm bid in the next 3year LTRO. However I see several problems to this theory: 1. The cost and benefits of such a move is way different to previous rate moves. With a large amount of excess liquidity being locked into the market, the impact on EONIA is likely to be minimal. The use of the MLF has dropped sharply since December and the ECB may be of the opinion that a sufficient boundary between the marginal rate and the refi rate (currently 75bp) serves as an incentive for financial institutions to handle their liquidity in a successful way. 2. The reduction in collateral requirements and the reduction in the reserve requirement ratio,  should ensure together with the 3year LTRO, that there are no volume restrictions for banks. Indeed, the ECB has always been of the opinion that the unconventional measures are aimed at improving the transmission mechanism. 3. With Euribor fix still in a down trend, there doesn’t seem to be an imminent reason for the ECB in trying to accelerate this trend. 4. I would argue that keeping a bit of spare doesn’t hurt anyone! If a more unfavourable economic situation occurs, or bank lending does not show signs of recovering in coming months, the ECB has a more fundamental reason to support the spending of its remaining ammunition. With regard to the economy, I expect Mr. Draghi to repeat his view that there are “tentative signs of stabilisation” (these signs have become a bit more pronounced with recent PMI surveys), whilst on the other hand the downside risks to the economy continue to be significant. Consumer spending data, for example, have been particularly weak lately. With regard to their inflation assessment, I expect the Governing Council to maintain a neutral view (a switch to downside risks would likely be a selling point if there is a rate cut). Whilst recent figures indicate that inflation is coming down now, the pace at which this is taking place is definitely slower than envisaged a few months ago, in part because of recent euro weakness and rising commodity prices. 5Y inflation swap contracts have risen by 40bp since November last year, an indication that the market is not buying into the deflation scenario, at least for now....

Guru’s thoughts: I strongly believe that the ECB will remain in ‘wait and see’ mode as there are too many variables that need to be played out. They still have bullets they can use and it’s all about timing. However I do think they will use at least one of these bullets in the coming months, I think the ECB will want to see the results of the 3year LTRO on the 29^th and then they can look to possibly cut rates further.