The ECB Gets Serious

A policy shift by the ECB seeks to curb disinflation before it gets out of hand.

The European Central Bank (ECB) took decisive steps on Thursday to support the economy and counter deflationary forces in the eurozone. The central bank lowered its benchmark interest rate to 0.15% from 0.25%, and also reduced its deposit rate below zero, to -0.1%, which will encourage banks to lend rather than park funds with the central bank. In addition, it is planning liquidity injections via targeted long-term refinancing operations (TLTROs) and will end SMP sterilization, which involved withdrawing euros from banks in amounts equal to what it was spending to purchase government bonds. Overall, we believe the combination of negative rates and rich liquidity should support performance in peripheral markets, lead to steeper yield curves and lower the euro exchange rate.

TLTROs with Clout

While it is difficult to judge how much liquidity the TLTROs will actually inject, we believe the amount will be significant. Banks could inject as much as EUR 400 billion in total on the two initial TLTROs, equal to 7% of total loans to the non-financial private sector (excluding loans to households). We believe it will be commercially attractive for any bank in the euro system to get up to four years' funding at a fixed rate of 0.25%.

Currency Is Key

Importantly, the ECB action is an effort to reduce the value of the euro, which, along with commodity price weakness, has been a key source of disinflation in Europe. Historically, the ECB has been reluctant to take aggressive measures until the data forces its hand, which has contributed to euro strength given looser monetary conditions in other regions. Although, in some ways, financial and economic conditions have greatly improved over the past couple years, the inflation rate has declined to uncomfortable levels last seen when the ECB intervened two years ago. While the ECB has successfully "talked down" the euro from its highs in May, we think these moves will provide further momentum for decline.

Investment Impact

In our view, the measures bode well for corporate credit conditions, in particular those of small and medium-sized businesses, which were a focus of the ECB action. (Large European corporations are typically very well capitalized and have good access to lending.) Looking at particular markets, we believe that German longer-term sovereign bonds may be vulnerable, given the potential for faster growth and inflation. In general, G-3 government bonds provide little upside given their low yields.

In contrast, we see some potential in peripheral European markets. Yields in Italy and Spain have reached new lows, benefiting from a positive rating cycle, good carry and rapidly improving fundamentals-which are likely to remain in place.

Future Measures Likely 'Unconventional'

It will take time for the macro implications of the ECB's actions to become apparent. Therefore, we do not expect further measures from the ECB for now, although the central bank stands ready to act, if needed. With inflation well below its target, the ECB will react to any significant rise in the euro. As ECB President Mario Draghi pointed out, each 10% exchange rate depreciation increases inflation by around 50 basis points. So the ECB must maintain, and preferably further amplify, recent weakness in the euro. With guidance now that rates will remain at present levels for an extended period, further action will not be on rates, but will be via unconventional measures.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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