Divyang Shah, Senior IFR Strategist
(This commentary is an updated version of one sent earlier today.)
Communicating forward guidance will be a big focus for the ECB as they look to flatten the money market curve either via:
1) more explicit language in the opening statement or
2) indicating a willingness to conduct longer term LTROs for packaged SME loans.
Money markets are no longer looking for the ECB to cut rates further, and the EONIA curve is instead looking for rates to move toward the refi rate in 2015. The ECB does not see this as being justified by its outlook for inflation, growth and unemployment, and this has been clear from recent ECB speakers including Draghi.
But it is also evident that words alone are proving insufficient to ease market concerns.
The question is what else the ECB can do to cement the view that rates will stay low for longer? The starting point of any discussion is to recognise that existing communication is not getting through so the options are:
1) a more formal statement reiterating that not only policy will stay accommodative but that rates will stay low for “as long as is needed”
2) a willingness to back up the talk with a further 25bp cut.
We know that when the ECB met in May there was appetite to deliver a more aggressive 50bp cut on the refi rate, so a surprise rate cut this week is a risk.
But cutting by 25bp now would likely not sit well as recent PMI data have shown improvement and inflation has moved marginally higher in June.
Thus it seems more likely the ECB will look to add more colour and clarity to its view that policy will stay accommodative with firmer language in the post-meeting statement.
The problem the ECB has is that the shift in sentiment has also been guided by a view on the outlook for excess liquidity. The 3-year LTRO repayments have been viewed as a positive trend by the ECB, but this has done little to ease concerns over money market rates moving up from their deposit rate floor.
There is the risk that the ECB could open the door to a future longer dated LTRO for banks that will instead be directed at SME related collateral.
We continue to view the money market curve biased toward flattening and have looked to
1) receiving 12x24 EONIA at 45bps with a stop at a wider 60bps and
2) a Jun5 Euribor call spread with 99.375-99.500 strikes.
