ECB Preview: Draghi Very Likely to Cut Again

We think a rate cut is very likely on Thursday and expect Mario Draghi to cut the refi rate to 0.25%. A deposit rate cut is very unlikely, in our view.
The ECB might present an instrument targeting lending to SMEs. The ECB is likely to work in tandem with other institutions on this.
The market is already pricing in an ECB refi rate cut and therefore there is a risk the ECB could disappoint.
Refi rate cut

At last month's Governing Council meeting, a rate cut was discussed and Draghi opened the door for the ECB to deliver a rate cut on Thursday. He said, 'we will monitor very closely....we will assess all incoming data in the coming weeks and we stand ready to act'. He also said that there were downside risks to the medium term outlook.

The main reason that the ECB has held rates unchanged in recent months despite weak numbers has been that the Governing Council held the view that as long as the mediumterm outlook is intact, the ECB should not cut rates further. However, the medium-term recovery in the euro area is dependent on a strong global recovery and since the last Governing Council meeting Chinese and US data have been disappointingly soft, which has called into question whether the drivers of the medium term recovery remain in place.

In addition, the correction in global commodity prices has made concerns about inflationary risks less valid. Germany has been one of the fiercest opponents of further stimulus, but the outlook for Germany has also weakened and its inflation fell from 1.8% to 1.1% in April, which may help to dampen resistance.

Finally, the markets are already pricing in a rate cut and the ECB hawks have not tried to alter these expectations. On 19 April, Jens Weidman said, 'of course, we will reassess the adequacy of the rates if the data changes' and the day after Jörg Asmussen said, 'the effectiveness of rate cuts is limited, but it's still possible to do this if data justified it'.

The impact of a refi rate cut on the real economy would probably be limited, as short market rates are currently determined by the deposit rate. However, this should not deter the ECB from trying. The most important effect of a refi rate cut might be that it will help to reduce the weekly repayments of three-year LTRO loans and thus slow the decline in excess liquidity, thereby delaying a shift in short market rates towards the deposit rate.

Deposit cut

Draghi has described a deposit cut to negative territory as 'uncharted waters' and said, 'the experiences in other monetary jurisdictions have shown that the unintended consequences of a measure like that can be serious'. Although we are unaware of such serious unintended consequences in other jurisdictions (Denmark, Sweden, Switzerland) the main message seems clear: Draghi does not want to cut rates into negative territory.

Lending to SMEs

Mario Draghi might present a non-standard instrument targeted at improving credit conditions for small- and medium-sized companies. Despite the very low policy rates, the situation for SMEs is that 'credit is either unduly expensive, given the quality of the client, or it is not there', as Mario Draghi said at the Q&A in March.

The bank lending survey published last week showed that credit tightening for SMEs continued in Q1. This picture was confirmed by the ECB's biannual survey on SME finance, which was published on 26 April. The report, which covers October to March, showed that 'access to finance' was the second largest concern for euro-area SMEs with a wide divergence across countries. 38% of the SMEs in Greece were concerned about access to finance, 25% in Spain, 24% in Ireland and 21% in Portugal, compared with 8% of SMEs in Germany and Austria. 'Finding customers' remained the dominant concern for euro-area SMEs.

In a speech given by ECB board member Benoît Coeuré on SME financing on 11 April, it was concluded that 'impediments are of three types: the banks' own funding conditions, their perception of the credit risk of their clients, and lack of capital....where the central bank has a direct role, within its mandate, is primarily with respect to bank funding conditions.' It was also said that, 'it is reasonable to think that simultaneous action on all three counts, by the relevant stakeholders in each case, would be mutually reinforcing.'

To us, this suggests that the ECB intends to act, but that a substantial part of the solution has to come from other institutions. Apart from this hint, there has been no indication from the ECB about what kind of instrument it would prefer to use.

One idea that has been floated is that the European Investment Bank should guarantee SME loans. National central banks have been allowed to accept bank loans as collateral since December 2011, but with substantial haircuts. If an EIB guarantee is attached, national central banks could then choose to apply very small haircuts. We think this is the most plausible approach although we think that the EIB as a cautious institution might be unwilling to present the large-scale programme that is needed to really make a difference.
Alternatively, the ECB could also introduce a funding-for-lending programme along the lines of the Bank of England programme, although it appears more complicated to introduce this in the euro area. Draghi hinted at this at last month's Governing Council meeting, when he said that the ECB will look at possibilities for using nonstandard measures within its mandate and that it will look at experiences from other countries.
Finally, the new instrument could take the form of a purchase programme where the ECB actively buys, for example, collateralised loan obligations.
Market reaction

The recent rally at the front end of the EUR curve and the tightening of the FRA Eonia basis suggest that a 25bp refi cut is priced in for Thursday's meeting. Meanwhile, the Eonia forward curve is only slightly inverted, suggesting a deposit cut is only priced in with a very low probability. Finally, we believe that the markets expect some sort of announcement on further non-standard measures (for example, a programme targeting SMEs). With regard to the SME instrument, the ECB might not be ready to announce anything yet and if it does, it could be very sketchy. On balance, we would rather be positioned for the ECB under-delivering than the opposite given the pricing - hence, a steepening of the money market curve and a flattening of the swap curve.

IMOH, Clement I.
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