Most "Priced In" Policy Since 2011 - Why Draghi Better Not Disappoint

Mario Draghi better put up or shut up at the next ECB meeting as the market is more-than-pricing-in a very significant deposit rate cut (deeper into NIRP). In fact, at -56bps, 2Y German bond yields are the most "priced in" since 2011 (and bear in mind he disappointed in December).

And in close up - Draghi "disappointed" in December

Though ironically that surge in yields in December enabled more Bunds to be eligible (albeit briefly) for Draghi's mass purchase scheme.

SocGen expects a 20bps cut, but warns "other tools" are possible including more OMT and helicopter money:

This is what is next on the ECB's agenda:

1. A 20bp cut in the deposit rate in March, to -0.5%, mainly in order to steepen the yield curve, likely with an announcement of an immediate or forthcoming introduction of a two-tier charge on excess reserves allowing the ECB to soften the impact on banks by exempting parts of excess reserves from the lowest rate. Our best “guesstimate” of the effective lower bound, based on the experience in smaller currency jurisdictions, is around -0.75%, but there is no technical limit per se;
2. Extension of the TLTRO for one year, also in March, with four additional auctions until June 2017. Given that the recovery in investment has been slower than expected, there is an argument for maintaining the incentives for lending to the corporate sector, until a sustainable investment recovery takes shape. We would expect the same conditions to apply in terms of banks’ reporting obligations and with a fixed interest rate at the current MRO rate, with loans maturing in September 2019 or possibly a rolling three year ahead horizon. A specific reason for the ECB to prolong this programme is that counterparties that used this facility in the first two auctions paid a spread (later abolished) and will be able to repay these loans (€212.4bn) as of September 2016. With both pricing and regulatory factors increasingly weighing on the current TLTROs, we see strong reasons for the ECB to be even bolder, be it by lengthening maturities (forward guidance) or lowering the interest rate, possibly even into negative territory. In case consumer confidence starts faltering, including mortgage lending in the TLTROs may be an option; and
3. Extension of the Asset Purchase Programme (APP) until December 2017. We currently don’t expect the (core) inflation outlook to improve sufficiently to end the APP in March 2017. Instead, we see a tapering to start around that point (reducing monthly purchases by €15bn each quarter), with purchases ending in December 2017, also in view of liquidity issues increasingly coming to the fore in 2017. This extension/tapering could be announced in H2 2016.

For the next meeting in March, we do not expect asset purchases to be accelerated, given the uncertainties over oil prices, the external outlook and liquidity. Recent concerns over banks’ profitability in an environment of low yields could also suggest some caution from the ECB to flatten the yield curve further, although, arguably, the ECB will also be concerned with pushing investors out of government bonds into less liquid and riskier assets. Importantly, any increase in the APP now would lead to questions over where the ECB could find assets in the future, if the APP is extended. A few clarifications could thus come as early as at the March meeting, depending also on the perceived financial market stress. Here we list a few options for the ECB in March, in order of likelihood:

• Expanding into non-financial corporate bonds remains a possibility, but with limited volumes available, easing stress in the credit markets. Similarly, expanding collateral eligibility, or accepting non-performing loans in certain ABS formats as collateral, could support the securitization market.
• Signalling the possible abolishment of the lower interest rate bound for APP. This limit is in place to stop the Eurosystem from making (automatic) losses on the APP. However, there is also a preference among some central banks for purchasing shorter maturities to avoid duration risk. A clearer agreement on profit and loss distribution in the Eurosystem could support an opening for allowing limited buying below the deposit rate, specifically enlarging the available German bond universe, although the legal hurdles still appear high;and
• Signalling that changes in the issue share limit for non-CAC bonds and/or the country share limit remain possible. However, we think it will be difficult for the ECB to motivate such changes, in particular as regards the country share limit, due to risks of such a move being perceived as supporting fiscally weaker countries. Allowing for higher purchases of non-CAC bonds would be easier but could impact negatively on fragmentation.

Other more technical options that are possible in March include:

• Details on purchases of regional government bonds;
• Expansion of the list of public agencies, including more utilities (bordering on corporate bonds);
• Following the Japanese example of adjusting the volumes for which negative rates are applied to mirror changes in cash holdings. This is an innovative way of removing the incentive to hoard cash (there is also some discussion on the merits of abolishing the €500 note, which would also make it harder to hold cash), and could thus make monetary policy more effective; and Sharpen communication on “forward guidance”, changing the current language of rates staying low for an “extended period”, or, better, providing future interest rate forecasts (à la the Fed’s dots or the Swedish central bank’s interest rate path).

Finally, here is a look at the ECB's full remaining toolkit:

With Draghi again signalling further easing, markets are closely scrutinising the tools at the ECB’s disposal. The remaining policy options relate to: 1) interest rates, 2) the asset purchase programme, and 3) liquidity operations, with each instrument depending on the nature of the challenges and the inflation outlook. Here is how we broadly see the ECB action panning out under different scenarios:

1) In a weaker (core) inflation outlook scenario:

• Cut the deposit rate down to its new lower “effective” bound of around -0.75%;
• Accelerate APP, with adjustments to the limits and assets likely if the programme extends well beyond March 2017.

2) In response to an unwarranted tightening in monetary conditions:

• Same as above, but without adding new asset classes and with only temporary foreign exchange interventions.

3) In response to increased fragmentation:

• Extend targeted liquidity for corporate lending;
• Reduce MRO rate, possibly to negative, to increase take-up of TLTRO.

Other tools are possible in more extreme scenarios, such as the use of OMT and helicopter money, but would need clear support from governments due to the potential fiscal implications. In extreme adverse scenarios with euro break-up risks, ECB purchase support ofrisky assets (bank bonds, ABS, equity) is also viewed as possible.

And finally, Goldman expects the ECB to ease monetary policy (by 10bps) at its March 10 meeting. More specifically, they expect:

• The rate on the ECB’s deposit facility to be cut by 10bp to -40bp.
• The announcement of an introduction of a tiered rate system for reserves, although the new system may become effective only at a later stage.
• The volume of monthly purchases to be increased by €10bn to €70bn.
• The parameters of the Public Sector Purchase Programme (PSPP) to be left unchanged ...
• ... but the prepared statement and/or Mr Draghi's comments during the press conference to stress that the PSPP parameters can be changed in principle should this become necessary in order to counter potential tensions in the financial system.