ECB goes sub zero

The ECB Governing Council (GC) cut its three key rates at yesterday’s monthly meeting. The main refinancing (refi) rate was brought down by 10bps to 0.15%, the marginal lending rate by 35bps to 0.40% and more importantly the deposit rate by 10bps to -0.10%.

These moves, which restore the symmetry of the ECB’s interest rate corridor, were broadly in line with market views – we had expected a slightly smaller cut in the marginal lending rate, while consensus estimates were looking for a refi rate of 0.10%.

However the broad thrust of the reductions was as expected, in particular the lowering of the deposit rate into negative territory.

Unconventional measures: The GC announced measures in three other broad areas:

1) The ECB will begin a new set of Targeted Long-Term Refinancing Operations (TLTROs), where the central bank will offer to lend cash to banks for four years, fixed at the prevailing refi rate plus 10bps;

2) The GC will step up preparatory work to purchase Asset Backed Securities (ABS) to improve the monetary policy transmission mechanism;

3) The ECB will conduct its main (i.e. weekly) refinancing operations at full allotment until at least December 2016. The same will apply to its three month operations. In addition it will no longer sterilise the weekly tender, which drains the liquidity from the Securities Markets Programme (SMP).

QE or not QE: Mr. Draghi was relatively quiet on the subject of QE, but he did say that large scale asset purchases were one instrument which the GC could use if it wishes to ease policy again. We maintain our view that operational and potential legal issues over conducting QE mean that the GC would rather not go down this route, but that it could be used as a last resort.

Market reaction: Market reaction was very volatile initially with the euro falling sharply (close to $1.3500) and stocks gaining momentum while Mr. Draghi was speaking, in the hope that he would launch a bombshell. However the overall package of measures had in practical terms already been well flagged, and the euro ended up trading modestly above the $1.3600 level prevailing before the rate announcement. In particular the ECB seems to be no nearer to launching QE than it was when Mr. Draghi was even coyer on the subject last month. The single currency is trading in or around $1.3650 as European markets open this morning.

Payroll Friday: The headline number today, as it is on the first Friday of every month, is the US non-farm payroll and employment data due at 1.30 this afternoon. After last month’s monster number of +288k, markets are looking for a smaller but still pretty substantial +215k print today. It is rare that we see payroll forecasts of over +200k and today’s expected number is one of the highest we have seen in recent years. Either way it should, as always, have a short sharp impact on the direction of the dollar this afternoon.

Currency thought of the day: Euro resilience increases likelihood of QE

While the rate cuts were well heralded, it would be very harsh to say that Mr. Draghi and co. under-delivered with their package of additional measures. The measures included extended full rate allotment, further LTRO and removal of the weekly liquidity drain from SMP purchases, just about everything that most economists had predicted, although very few suggested that they would unleash all three together. They also mentioned that they are undertaking preparatory work related to outright purchases of ABS securities (full blown Quantitative Easing), keeping something in reserve for future policy meetings.

While the euro initially weakened, a flood of funds into European assets sent European equities higher, tightened bond yields and saw the euro recover back to pre-announcement levels against both the pound and dollar. If the euro fails to weaken over the coming month the pressure on the ECB will continue to grow to announce new measures. While there are a number of difficulties (largely political) with implementing an asset purchase scheme across the Eurozone, the performance of the euro yesterday may leave the ECB with very little choice but to unleash the big guns next month and roll out a full blown quantitative easing programme in July.