Markets Watch ECB Meeting

Will the ECB cut rates on Wednesday? In a Reuters poll 75 of 75 analysts say no (including us), so let us not waste much time on this.

What else can Mario Draghi do? He can do his best to sound dovish and emphasise the weakness in some hard data and credit data and downplay the improvement in soft data. He can also repeat the "extended period" forward guidance and signal that rate cuts are still more likely than rate hikes in the near future. However, in our view, the obvious to many next big step ahead, a shift to rule-based forward guidance, will not be taken. Last month, Draghi clearly said regarding forward guidance, 'we do not want to change it'.

Draghi could also flag that further policy easing is likely to come. On several recent occasions, a new LTRO has been mentioned as a possible next policy step. However, the timing is uncertain. Benoit CSuré has said that adding liquidity to the system is not an 'urgent necessity'. We agree with this. Excess liquidity is currently around €225 billion and the decline in excess liquidity has not yet pushed short market rates abruptly upwards. We expect the ECB to provide further easing, probably in the form of a new 3Y LTRO, when excess liquidity has declined so much that it pushes short market rates notably higher. We think this could happen late this year or early next year.

The main problem that the ECB should address is the continued credit contraction across the euro area. The lending data published last week showed that the credit contraction continues at an almost unchanged pace. It is not unusual for credit growth to lag the business cycle but a continued decline in lending is, in our view, one of the key risks for the euro area recovery.

In this regard, the effectiveness of a new 3Y LTRO is questionable. The ongoing credit contraction is driven partly by banks' deleveraging in a wish to fulfil and over-fulfil upcoming regulations. The demand for new liquidity may thus be limited unless the ECB adds some sweeteners. It is not clear to us what the sweeteners could be.

Last week, Benoit CSuré said that, "if there is a need to act, the ECB has a range of options to address it'. Apart from the LTRO, the ECB could further reduce or remove reserve requirements. This would free up to EUR100bn on banks' balance sheets. A funding for lending programme is another option but the ECB would have to think hard about how to make it effective. On Wednesday, Draghi might give us a few more ideas about what instruments the ECB is considering.

The general perception in the market is that the ECB will do nothing at this meeting, so while non-action should cause very little disappointment any policy move would be a complete surprise and could trigger a pronounced market reaction. In the absence of expected policy moves market participants will listen for how dovish Draghi sounds. There is a risk that investors will be disappointed if Draghi's wording fails to be really dovish and then rates could go higher, yield curves flatten and EUR/USD could strengthen.

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