ECB rates cut Thursday might not cut it
Banks aren't convinced that a rates cut at the European Central Bank will lead to any improvement in the eurozone's situation.
The consensus is that the ECB will cut rates on Thursday in response to weak growth in the eurozone. President Mario Draghi hinted at the possibility of such a cut at a press conference in June by revealing that a minority of the governing council were in favour. Société Générale sees the possibility of a rate cut as higher due to softer-than-expected prices in Germany for June; year-on-year increase in prices were down from May.
“German figures tell us a simple story: the sharp decline in oil prices is bringing forward the point at which euro area inflation will fall below the ECB’s 2.0% objective (by November 2012 basing the forecasts on oil futures prices and by March 2013 using SG Commodity Team forecasts). This reinforces our call that the ECB will cut its refinancing rate by 50bp to 0.5% next week.”
The most common prediction among banks seems to be that the ECB will cut interest rates to 0.5% and the deposit rate to 0%. Nomura has put out some cautionary research outlining some of the possible risks associated with bringing the deposit rate down to zero:
“The ECB deposit facility becomes irrelevant.
Today, banks can move excess reserves from their ECB current accounts (where excess reserves gain 0% interest) into the deposit facility, where the excess reserves today are remunerated at the deposit rate of 0.25%. If the deposit rate is cut to zero there is no incentive for banks to use the ECB deposit facility, meaning excess deposits can be left in banks' current accounts. Cutting the deposit rate to zero therefore could trigger changes to how banks manage their liquidity flows. And a 0% deposit rate removes the 25bp remuneration that European banks receive for their excess reserves sitting in the ECB's deposit facility. Hence, a deposit rate cut in isolation (i.e assuming the policy rate stays unchanged) hurts the profitability of the banking sector.
Greater disintermediation on the money markets.
With money market rates close to zero, the compensation for lending in the interbank market may not be sufficient to compensate for counterparty risk. Instead, market participants will choose to borrow from the ECB instead. The end result would be more reliance on ECB borrowing and the ECB would increasingly become the sole provider of money market liquidity. This would prolong the ECB's exit strategy; something the Bank is not comfortable with.
Delays balance sheet adjustment.
Pushing interest rates to their de facto lower bound could signal that rates will remain low for a very low time. The ECB is aware that this could lead to new lending bubbles and may delay the inevitable deleveraging process. Short-term concerns may require very low rates but this can fuel longer-term financial stability issues.”
Nomura also seems doubtful that the cuts will lead to any meaningful improvement in the eurozone's economic situation; and while it may warn of the risks of a deposit rate cut, it endorses the arguably more extreme measure of quantitative easing and Eurobonds as policy responses that could provide a lasting solution to the crisis.
SocGen has also indicated that rate cuts may no longer be up to the task, and that the ECB may need to look to other tools. It isn't convinced that adding a new LTRO or extending the maturity is necessary, unless we see a sharp drop in bank liquidity. Similarly, a new covered bond purchase programme is something that the bank thinks would only help at the margin.
SocGen suggests that expansion of the securities market programme could improve sentiment by showing the ECB's willingness to act and encouraging a buy flow at Spanish and Italian bond auctions - and it seems increasingly plausible that sentiment is the key in the eurozone crisis. But ultimately, SocGen thinks that the programme's already hefty size (€212.2 billion as of June 12) means that the ECB will be reluctant to turn to it.
So, while SocGen has a pretty good idea of what won't work, they don't have anything more constructive than that. Perhaps Nomura has the right idea.