- The ECB has introduced a comprehensive new stimulus package, including lower deposit rates and QE.
- A tiering system should help mitigate the costs to the banking sector resulting from negative deposit rates.
- New measures are unlikely to boost growth or inflation significantly, but could reduce financial turbulence.
- We suggest investors should continue to focus on credit “carry” and remain cautious on equities.
The ECB announced today a comprehensive package of monetary stimulus to support the Eurozone economy and ensure price stability. The package has four key components:
- Lower deposit rate: the interest rate on the ECB’s deposit facility will be decreased by 10 basis points to -0.50%. The main refinancing rate and the marginal lending rate will remain unchanged at 0.00% and 0.25% respectively.
- Tiering system: In order to support the bank-based transition mechanism of monetary policy, a two-tier system for bank deposits with the ECB will be introduced. Banks can (from October 30) exempt six times their required minimum reserves from the negative deposit rate.
- Relaunch of quantitative easing: Net purchases under the Governing Council’s asset purchase programme (APP) at a monthly pace of €20 billion will start as from November 1, with no finish date specified.
- Better TLTRO III conditions: Modalities around targeted longer-term refinancing operations (TLTRO) will be changed to preserve favourable bank lending. The 10-basis point rate premium will be scrapped and maturity increased from 2 to 3 years.
Forward guidance was reinforced and is no longer calendar-based. In fact, the ECB sees rates at present or lower levels until inflation “robustly” converges to the target of sufficiently close to, but below, 2% supported by underlying dynamics.
Furthermore, Mario Draghi mentioned that risks to the Eurozone economy remain tilted to the downside. The ECB’s GDP forecast for 2019 have been revised down (from 1.2% to 1.1%) as has the forecast for 2020 (from 1.4% to 1.2%). Inflation forecasts have also declined: from 1.3% to 1.2% for 2019, from 1.4% to 1.0% for 2020, and from 1.6% to 1.5% for 2021.
How did markets react?
European government bonds rallied on the announcements. 10-year German government bond yields declined by 6bps. 10-year Italian bond yields fell by more than 18bps to a new record low. The EUR/USD exchange rate dropped to close to the lowest intraday levels since 2017, before bouncing back. The Euro Stoxx 50 index is, at the time of writing, up by 0.8%. Banking sector stocks in the index have proved quite volatile. They initially gained 1.8%, before dropping as much as 4.4% and are now little changed on their pre-announcement levels.
What does it mean for investors?
The economic situation in the Eurozone has deteriorated over the summer months. The manufacturing sector is suffering in particular from the trade war and political uncertainty. The situation is more pronounced in export-oriented countries with a large industrial sector. While consumer spending has been resilient, business sentiment and investment has weakened significantly.
The ECB’s attempt to stimulate credit growth with even looser monetary policy might not be able to boost economic growth significantly. After all, Eurozone corporates are hesitant to invest largely due to the uncertain political and economic outlook, not because of high financing costs. On the other side, the monetary package may help to reduce financial turbulence.
Lower deposit rates threatened to increase the interest rate costs for Eurozone banks (currently EUR7-7.5bn per year) even further. Hence, the introduction of a tiering system was necessary to support the bank-based monetary stimulus transmission mechanism. We estimate that the interest burden for Eurozone banks will decrease by around EUR1.4bn with today’s announced measures.
Today’s ECB package strengthens the “hunt for yield” environment. The relaunch of asset purchases will likely keep bond yields at ultra low levels for longer. We suggest the EUR crossover space as a possible interesting “carry” opportunity in the fixed income universe. On the other hand we remain cautious on European equities in the short run as economic risks remain tilted to the downside. EUR/USD downside potential remains limited as the U.S. Fed will likely loosen monetary policy later this month and the EUR yield differential vs. the USD is expected to narrow.