ECB Set To Cut Rates To Record Lows

We adjust our ECB rate forecast by adding a 25bp rate cut in January 2012 following the already anticipated 25bp cut in December 2011. This will bring the refinancing rate down to a historically low 0.75%.
We also expect the ECB to narrow the interest rate corridor in January in order to avoid having zero interest rates. Keeping the deposit rate at 0.25% leaves banks with the option of offering slightly lower rates to their own depositors.
The reasons for expecting further cuts from the ECB are threefold: 1) Recent data have been disappointingly weak; 2) The economic outlook has worsened as euro area leaders have failed to contain the debt crisis; 3) ECB hawks have turned soft.
A final rate cut in February or March bringing the refinancing rate to as low as 0.5% cannot be ruled out if the deterioration in hard data intensifies. However, this is not our main scenario.

Weak data and worsening of the economic outlook
Recent data have been disappointingly weak. Industrial production fell sharply in both
Germany and the euro area in September. German industrial orders indicate further decline in the coming months. Unemployment has begun to increase after a period of
decline in both Germany and the euro area. The euro area PMIs are also sending out
strong recessionary signals and so far show no signs of stabilising. Our speed limit
approach based on composite PMI new orders now signals that the ECB should cut rates
by 0.7% on a three-month horizon. This is consistent with the ECB cutting rates not only
in December 2011, but also in January 2012.

The economic outlook continues to deteriorate as euro area leaders have so far failed to
contain the debt crisis. Hopes that leaders will succeed in the short term have diminished
as the EFSF’s new firepower is likely to prove unconvincing. The continuation of the
elevated risk environment is now causing a euro area recession, which may last for two
quarters, but could last longer unless more impressive action is taken, see Euro area in
recession, US and China recover.

In addition, inflation expectations in the ECB’s Survey of Professional Forecasters have
come down, which should make the ECB comfortable that upside risks to inflation are
limited. Indeed, in the current recessionary environment it should be more concerned that inflation could undershoot relative to its policy target. This gives the ECB plenty of
leeway for lowering rates to new record lows.

Based on Mario Draghi’s first ECB press conference, it appears that he is slightly more
focused on growth figures than Jean-Claude Trichet was and that he might be willing to
react more promptly to a deterioration in the growth outlook. Thus, ECB policy setting
might have moved a step closer to the FED approach, which also argues for the ECB to
cut rates more aggressively in the current environment. Draghi went as far as mentioning
leading indicators such as PMI manufacturing and even the deteriorating new orders
component at his first press conference. This is a change in style from Trichet.

ECB hawks turn soft
In recent days several ECB hawks have turned soft and signalled that the ECB has room
to lower rates further. Given the seriousness of the current downturn this has led us to
believe that the ECB will cut rates below the previously record low 1%.

Notably, last Friday Ewald Nowotny said, “If there is a situation that we see a serious
downturn, or the danger of a serious downturn in Europe, taken together with the
perspective of price stability, then I think it’s time to rethink and to act maybe in a more
decisive way” and, “If price stability is achieved and if we have stable inflation expectations, then the ECB has the power, and to a certain extent also the need, to offer
positive help for the economic situation”.

Also on Friday, Jürgen Stark went as far as saying that, “When you compare the level of
interest rates in the euro zone with those in the US, UK or Switzerland, where rates are
close to zero, then we’re the only ones still with room for manoeuvre”.

According to Mario Draghi this month’s rate cut was unanimous. Given the softened stance of these hawks it is plausible that the upcoming rate cuts will be unanimous too.

Interest rate corridor
We expect the ECB to narrow the symmetrical interest rate corridor by 25bp on each side
in January in order to avoid having zero interest rates. The deposit rate will thus remain
unchanged at 0.25% while the marginal lending rate will be lowered by 50bp to 1.25%.
Keeping the deposit rate at 0.25% leaves banks with the option of offering slightly lower
rates to their own depositors.

Market reaction
All major ECB forecasters anticipate that the ECB will stop cutting the refinancing rate at
1.0%. It is becoming increasingly difficult to extract the market’s rate expectations but
based on the Euribor and the Eonia curve, the market seems to be pricing roughly one
more 25bp cut in the refi rate at the December meeting, where after the ECB is set to be
on hold (implied rate from 3M Euribor futures still not below 1%).

With the ECB cutting the refinancing rate below 1%, which we now believe, there should
be room for lower implied forward rates in the Euribor future strip. In turn this should
feed into lower 2yr swap rates and to some extent also lower 5yr swap rates in the coming months. The Eonia market forward rates are close to the bottom and we do not see particularly much room for lower rates here – even if the refi rate is cut below 1%. The Eonia forward curve is already anticipating fixings around 0.40% and we do not believe that fixings are likely to fall much below this level, with the deposit rate at 0.25%. At least this is the experience from 2010, when the O/N market was awash with liquidity and the deposit rate was at 0.25%.