EUR Rates: After The ECB Meeting‏

The decision by the ECB to cut the refi rate by 25bp to 0.25% ignited a relatively strong rally in the front end of the swap curve. 1y fwd rates initially declined by as much as 15bp in the 2-5y segment.

The cut initially had a somewhat stronger impact on the market than we would have expected beforehand. There were already wide expectations of the ECB to signal a cut in the refi rate by December, but the decidedness by the ECB, must have caught the market a bit by surprise.

Following the press conference the market took back around 5bp of the initial rally, as Mario Draghi did not signal any imminent further easing. This left a net reaction of about 10bp in the 1y fwd rates of the 2-5y segment of the EUR curve.

ECB regains control over the money market curve
The most important aspect of today’s refi rate cut is that the ECB has effectively regained control over the money market curve by narrowing the spread between the refi and the deposit rate to 25bp.

It will now be of much less concern if the amount of excess liquidity continues to decline, because the EONIA O/N rate will be capped by the refi rate at 0.25%. Consequently, the EONIA curve has flattened and 1Y1Y EONIA rates now trades around 0.22% - down from 0.30% yesterday . This seems like a reasonable level in a scenario where the ECB does not cut rates further and the liquidity situation continues to normalise.

One and done, but when to fade the rally?
Negative deposit rates were discussed at the press conference. Draghi mentioned that the central bank is ready to handle negative deposit rates, but also hinted that this was not currently on the table. The EONIA curve has flattened further in the 1-12 month segment, but it has not inverted. This indicates that the market is still not pricing any material probability of negative deposit rates from the ECB.

Although the ECB clearly retained its easing bias, we see this as the last rate cut from the ECB in most scenarios (“one and done”). However, it is now clear that the downside risk to inflation has become a more prominent factor in the reaction function. Hence, if growth remains too weak to break the upward trend in the unemployment rate, a further material decline the inflation could bring on the discussion of further easing and potentially negative rates.

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