Handicapping The ECB Meeting

The ECB meets tomorrow.  The combination of soft inflation data and Draghi’s speech at Jackson Hole has raised expectations for a policy response. 

Many observers have played up the risks of an asset-backed securities (ABS) purchase scheme for which Draghi said preparations are moving forward quickly.  We are more skeptical that the ECB is prepared for this.  There are many moving parts, and not all of them are controlled by the ECB.  Moreover, the issuance of ABS varies greatly through the eurozone, though if the ECB did announce a purchase plan, we could envision banks manufacturing more.  

Rather than an ABS purchase program or an outright QE, we expect more modest measures by the ECB.  We think a 10 bp rate cut to bring the repo rate to 5 bp is likely.  The deposit rate, which is already set at minus 10 bp could be cut further, and the top of the corridor, the 40 bp lending rate could also be shaved.  

Recall that in June in response to the last rate cut, including the negative deposit rate, the euro initially sold off and then rallied to a two-week high.  There was marginal follow through buying the following day, but then the euro slipped lower.  Still, it did not take out the low set initially on the ECB announcement until late July.  

ECB officials seem focused on the Targeted Long Term Repo Operation (TLTRO)  that will be launched toward the middle of this month.  Some observers share our concern that for various reasons the participation may not be as strong as hoped.  The purpose of the TLTRO is to boost private sector lending, and demand is not particularly strong.  Banks are still paying down the LTRO borrowings.  The carry opportunity is not as great.  There are more reporting requirements.  

The ECB may announce more details of what it has called “modalities” or rules of engagement for the TLTROs.  Some small banks, which do not have access to the ECB’s facilities, could participate in the TLTRO through a larger bank, for example.  Although the ECB has indicated this, few have focused on the implication.    Since the cost of TLTRO funds is 10 bp above the repo rate, a repo rate cut on the eve of the TLTRO may also help encourage stronger participation.