Preparing for the ECB: Fixed income or fixed loss securities?


Staff member
Tomorrow will be an important day for investors in foreign exchange: In its most anticipated meeting in months, the European Central Bank is expected to announce a package of fresh stimulus measures, including another cut in its deposit rate, a renewal of its bond buying programme as well as a tiering of its deposit rate. Each of these measures would be supportive of the economy by itself, but combined they surely must have a big impact on the economy in the eurozone or at least on business confidence, you might think. The real threat, however, is that expectations might be too big:

Economists and bank analysts expect a 10 basis point cut in the ECB's deposit rate from -0.4% to -0.5%. A minority even expects a cut by 15-20bp! Is this really necessary though? True, economic data from countries like Germany have mostly been disappointing lately. Brexit is still posing a very serious risk to trade in Europe. Sino-U.S. tensions keep the world gripped. But these are merely uncertainties so far. The eurozone economy is not facing an imminent recession threat. Stocks in many parts of the world are near all-time highs. Unemployment is quite low. There is inflation, i.e. no deflation danger, even though inflation in the euro area remains below the ECB's (rather arbitrary) 2% target. Market participants and individual members of the ECB board have taken these points into account. Not everybody is supporting Mario Draghi, who is believed to advocate the above-mentioned stimulus measures. In my opinion, we will see a 10bp rate cut (although I do not see a necessity for it!), but we will not see a cut by more than that. Expectations are high and Draghi & Co. know this. The overall picture might indeed be just a tad too uncertain to disappoint these expectations altogether.

I also think the ECB will pair the rate cut with the introduction of a tiering in its deposit rate. The negative deposit rate has been a heavy drag on the profits of banks in Europe, especially for those with lots of excess liquidity that needs to be parked somewhere. Banks have tried to avoid passing the deposit penalty on to their customers for a long time. Retail clients still don't need to pay negative interest on money in their accounts, unless they are high-net-worth individuals perhaps. That means banks have internalised much of the cost of parking money at the ECB. In addition, the introduction of strict regulations over the past couple of years, including MiFID II and higher capital requirements, have also increased costs at European banks, making it harder for them to compete internationally. To reduce the strain from negative interest rates on banks, the ECB must have been pondering the introduction of a tiered deposit rate. Countries like Denmark, Japan and Switzerland have a tiered system in place already. While I think such a step would make sense, especially when considering to push rates even further into negative territory and keeping them there for a prolonged period of time, this step is far from certain. There have only been rumours that the ECB is discussing this, and which variation they would prefer is an entirely different question.

Finally, the ECB might announce a new round of quantitative easing (QE) by pledging to buy more government and corporate bonds. This is the most tricky part of tomorrow's meeting, in my opinion. First of all, eligible bonds are relatively scarce these days. Many government and even some highly rated corporate bonds have negative yields already. Central banks are holding many of these bonds, with the remainder being bought up by large institutional investors who must invest their liquidity in relatively secure fixed income securities in order to avoid even more negative interest rates in their cash accounts. (Charges of 10-30 basis points below the ECB's deposit rate, i.e. up to -0.7% p.a. are not unusual.) Come to think of it, when will be begin to call fixed income securities "fixed loss securities"!? The negative bond yields also suggest investors are already positioned for such a step, making for lots of potential for a disappointment if the ECB underdelivers. Given the market's expection of roughly 30 billion euros in bond purchases per month for starters, anything below that could be seen as such an underdelivery, pushing bond yields higher again. On the other hand, if the ECB announces to additionally buy stocks or to specifically buy bank bonds, that would be seen as a positive surprise. I think that is highly unlikely though, taking into account the political complications of the second step. Also, the ECB doesn't need to use all of its firing power now. As I said earlier, the economy is not doing that badly, so better keep some powder dry for when you will need it in the future! My prediction: The ECB will restart its bond buying programme so it can pump more fresh money into the economy in an effort to at least jostle inflation a nodge closer towards its goal of 2% annually. Inflation expectations suggest that goal might still not be reached for a long time.

What does all that mean for the EUR/USD exchange rate? That question is not straightforward to answer. You might think all of the measures above should push the euro lower, but the opposite might be the case at the end of the day. To begin with, short-term expectations are for the euro to depreciate versus the US dollar. The spot rate is still in a downward trend, although supports in the $1.09-10 area have held repeatedly during the past few weeks. Non-commercial futures positions at the CME are firmly short the euro, albeit not close to record lows. That means many market participants are already positioned for this scenario. More importantly, I believe investors are not going to change their positions too much before the Federal Reserve's FOMC meeting next week. The Fed is still the more powerful player, because it has already raised rates and stopped QE, making it easier for the Fed to scale up its stimulus measures. The ECB is already running the risk of exhausting its possibilities - a worrying prospect for when the economy will actually be falling into a recession! All in all, the Fed has a lot more room to surprise on the dovish side than the ECB does. Building up significant USD long positions before the FOMC meeting would be very risky, and investors know this. My base scenario is therefore for EUR/USD to fall slightly within one big figure during the ECB presser, if Draghi delivers most of what is expected of him, but the euro will then consolidate until next week or even go higher in anticipation of any Fed stimulus. If Draghi does not fully deliver any of the above stimulus measures, especially on the rate cut and QE, the risk is firmly on the upside and we might see EUR/USD going back up towards $1.11-12.