A Refi Rate Cut Would Be The Most Likely Easing Measure ‏

A combination of mixed European growth data, slowing inflation and renewed political uncertainty in Italy has fuelled speculation that the ECB will cut its refi rate in the coming months. Our main view is that the ECB will keep rates unchanged – a view based on an expectation that euro area data will improve in the coming months (see ECB preview).

The risk of a rate cut on Thursday is limited, but the trickier part is whether rate cuts have been discussed and the decision to stay on hold was unanimous. The specific phrasing from Draghi on this topic is likely to be key to the initial market reaction. Fundamentally we believe that risk reward is in favour of a steeper money market curve over the coming months. However, we prefer not to take a position ahead of the press conference, as the market has previously been very sensitive to nuances in Draghi’s comments.

A refi rate cut would be the most likely easing measure
Although we do not expect it, a lowering of the refi rate is currently the most likely measure for easing monetary policies further. A cut in the refi rate will secure lower rates for the economy and reduce future volatility in the money market as it will lower the upper bound Eonia O/N when the 3Y LTROs expire in February 2015. Assuming that excess liquidity will decline towards zero, Eonia O/N should fix 0.70% for an unchanged (0.75%) refi rate by early 2015, while it should only increase to around 0.45% if the refi rate is lowered to 0.50%.

If the refi rate is cut and the deposit rate is left unchanged, the rate corridor is narrowed. A narrowing of the interest rate corridor is a significant move and would, in our view, signal some resistance within the ECB to lower the deposit rate below zero. Hence, we expect a reduced likelihood of negative deposit rates in this scenario, which would also contribute to lower volatility in the money market.

What is priced in?
It is not an easy task to back out the implicit market expectations for the refi rate and the deposit rate in the current market. However, the Eonia forward curve is roughly flat through 2013, indicating that no deposit rate cuts are priced in and that excess liquidity will remain abundant throughout the year.

For 2014, the Eonia forward curve is only moderately upward sloping. The Eonia O/N is priced for an increase to around 0.35% by February 2015, when the 3Y LTROs expire. This is consistent with one of the two scenarios. (1) A market expectation of a refi rate at 0.50% and excess liquidity around EUR50-150bn at that time. (2) Unchanged refi rate and continued abundant excess liquidity (a continuation of the full allotment policy from the ECB with some banks still being shut out of the funding market).

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