- In this note we focus on the lower bound of the European and Danish money market rates, given the outlook for the ECB and the Danish central bank.
- Our economists expect that the ECB refi-rate will be cut by another 50bp to 0.75% by January 2012. However, the deposit rate is only likely to drop 25bp to 0.25%.
- A deposit rate at 0.25% and rich liquidity should eventually result in an EONIA O/N fixing around 0.40% – perhaps slightly lower from time to time.
- We expect the Danish central bank to track to the ECB. Hence the lending rate should drop 50bp to 0.70%. Meanwhile the CD rate is cut 25bp to 0.40%.
- Usually the Danish T/N money market rate fluctuates around the CD rate. Hence we expect a floor of about 40bp for Cita rates, but there are downside risks.
- More independent Danish rate cuts cannot be excluded and the T/N fixings can remain below the EONIA fixing going forward, if Denmark remains a safe haven.
- A Deposit rate at zero could jeopardise the ECB’s ability to reabsorb the excess liquidity created from excess bidding in MRO/LTRO and from the Securities Market Programme (SMP).
- The ECB’s liquidity management has proven to be very steady in handling the extreme behaviour by banks and in handling SMP. Banks and eventually client behaviour in a 0% rate environment could become more erratic and jeopardise the stability in EONIA fixings. A deposit rate at zero may involve undesirable incentives for agents involved in repurchase agreements (REPOs).
- Another argument for narrowing the rate corridor, rather than lowering the deposit rate in tandem with the refi rate, is that the ECB could regain some its lost control over money market rates if the rate corridor is narrow (e.g. +/-25bp).
- A tighter rate corridor and sharply lower marginal lending rates would probably support lower Euribor fixings and consequently lower swap rates at short to medium tenors. This in turn is likely to tighten the Schatz asset swap spread from the current elevated level and bring relief to markets and banks in the Eurosystem.
ECB to deliver more rate cuts at upcoming meetings
Our economists now sees the ECB cutting the refinancing rate by 25bp at each of the
next two Governing Council meetings of the ECB – on 8 December and 12 January –
bringing it to 0.75%. See Yield Forecast Update. As we argue below the deposit rate is unlikely to drop below 0.25%, hence the rate corridor is expected to be narrowed by 25bp to +/-50bp – see table. The risk is another cut in the refi rate of 25bp to 0.50%, which in our view implies that the interest rate corridor could narrow by another 25bp and the marginal lending rate could fall to a mere 0.75% from the current 2% level.
ECB deposit rate bound at 0.25%
There are several reasons why we do not see a case for the deposit rate going below
0.25%. A common factor for the explanations is that we believe a deposit rate of zero, or close to zero, does not support restoring monetary policy transmission mechanisms – which is something the ECB has put emphasis on recently.
EONIA fixings bound some 10bp above the deposit rate
So what does this imply for the EONIA fixing? Going forward, we expect excess
liquidity to remain high and possibly increase. We cannot exclude the idea that the ECB will introduce 24-month tenders with unlimited amounts to secure longer term liquidityfor banks in the Eurosystem.
We expect that EONIA fixings would eventually decline to about 0.40%, measured over a maintenance period of roughly one month, if financial stress eases. Hence we expect the credit premium between the deposit and the EONIA fixing to be around 15bp. However, recent history shows that it could decline to deposit +10bp. This was seen in longer periods in 2009 and 2010. However, that was before the escalation of the euro area debt crisis.
Floor for Danish rates to move in tandem with EONIA fixings
The Danish central bank is expected to track the ECB and cut the Repo rate by another 50bp to 0.70% in January 2012. The current account and CD rates should decline by only 25bp, as they move in tandem with the ECB deposit rate. Hence the CD rate is expected to be reduced to 0.40% as the deposit rate is cut to 0.25%.
The Danish T/N fixing usually fluctuates closely around the CD rate. Hence the 40bp
level is a crude estimate of the floor of Danish money market rates. However, there is a risk of independent Danish rate cuts leading to even lower money market rates.
This would especially be likely if Danish markets remain perceived as safe haven leading to more currency inflow and appreciation pressure on the Danish currency. The FX reserves are approaching DKK500bn and the central bank is unlikely to accept much appreciation of the Danish krone. Therefore the CD rate could be lowered independently, by another 10bp. Also if the EONIA rates fluctuate in the low to middle 30 basis points, there could be a case building for independent rate cuts.
Overall, we see significant downside potential for Danish money market rates in the
coming months. On top of the risks of independent cuts, there is also the risk that the
ECB comes in faster and with greater force to push down money market rates by up to two years tenor.
The Danish forward money market curve is not pricing this in, as rates are probably squeezed at the current juncture due to the ongoing refinancing auctions of Danish mortgages. But as refinancing auctions are carried out and the December meeting approaches, there is significant downside potential for Danish money market rates.
Position for ECB cuts in Danish money markets
Judging from the EONIA forward curve, there is limited potential to price in more ECB cuts, assuming a floor of 0.25% for the deposit rate and around 0.40% for the EONIA fixing, since forward rates measured over maintenance periods are already close to 0.40%. Meanwhile, there appears to be more downside for Danish money market rates, as they fluctuate around 0.60%. Especially attractive are forward rates 6-12 months ahead, since they fluctuate close to 70bp. This implies at least some 30bp downward potential if the T/N fixing is realised no higher than 0.40%, as is our expectation. Hence receiving 6M6M Cita rates appears attractive, when the Danish refinancing auctions are done.