We believe the ECB will surprise the markets by boosting liquidity through a new 3Y LTRO while at the same time cutting the refi and deposit rate, bringing the latter into negative territory.
The market is prepared for further ECB measures in coming months, but if the ECB delivers aggressively like we expect it to, then markets will be surprised and it will push down money-market rates even further.
Lower money-market rates should follow, as by crossing the invisible line of a negative rate the ECB signals further deposit cuts can be priced. Also, in the case of a new LTRO then we expect strong demand and thereby significant liquidity.
A new LTRO could be made even more attractive than previous ones by keeping the rate on the instrument fixed until maturity. In this way, the ECB would affect longer term interest rates and hence strengthen its forward guidance.
A targeted LTRO could also be considered in order to improve the transmission mechanism. An ABS purchase programme is a possibility but we expect the ECB to wait for the result of its Asset Quality Review and the stress test.
Lower rates and more liquidity should limit the upside risks to the exchange rate and at the same time reduce the negative impact on inflation from the appreciation of the currency.
In our next two papers, we will consider the implications of negative rates and consider whether this is the end of the ECB's easing cycle.
To Read the Entire Report Please Click on the pdf File Below