We have a strong conviction of additional easing from the ECB. Medium-term inflation will be below target and, in the current monetary policy regime, deviation from the price stability target is crucial for the interest rate setting.
Stopping the sterilisation of the SMP seems to be a done deal for the March meeting. However, it only underlines the accommodative monetary policy and the temporary boost to liquidity buys the ECB more time. However it will not be the end of the easing cycle.
An implication of halting the SMP sterilisation is that the ECB recognises that SMP was de facto QE and it could open the door for new ECB easing measures. We do not expect an announcement of a QE programme in March but Draghi could try to use it to as verbal intervention.
We maintain our view that the ECB will cut to negative deposit rates in Q2. The outlook of a prolonged period of low inflation will lead to additional easing and so far ECB communication has been in favour of this instrument.
A negative deposit rate would imply higher costs of holding deposits at the ECB, causing an intensified search for positive yields among investors, which would drive down yields on shorter maturity bonds.
In the fixed income market, the reaction depends on the communication attached to a policy action. Rates in the 2-5Y segment could decline further if the ECB indicates deeper cuts into negative rates or outright QE policy. Any easing should be supportive for spread compression.
In the FX market, notably a deposit cut to negative territory would foster significant EUR downside through downward pressure at the short end of EUR money market curve.
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