An ECB Rate Cut Will Make QE Inevitable

The European Central Bank faces quite a conundrum ahead of its upcoming monetary policy meeting on September 12. ECB President, Mario Draghi, has clearly signalled that a cut to the refinancing rate (currently at minus 40bp) is likely and markets are now pricing this in with an 85% probability. The problem is, the ECB has also signalled that it will simultaneously consider tiering the bank reserves this rate actually applies to.

A quick explanation of the need for tiering is that the transmission of monetary policy below a zero rate has been impeded by the commercial banks not being willing, or maybe able, to pass a negative rate on to their clients in the form of negative deposit rates. You could think that at least part of their deposit base would respectfully decline if they were asked to pay for the privilege of having their own money in a bank account. In theory, the system could face some form of deposit flight. This results in banks having an asset on their balance sheet with a negative yield (money with the ECB)  and a liability that on average has a positive yield (deposits). From a systemic point of view the amount that banks currently have in their accounts with the ECB stands at €1.85 trillion, of which the vast majority is “earning” -0.4%. This equates to an annual cost for the Eurozone’s banking system of close to €7.5 billion, most of which is being borne by Europe’s core banks.

Historically this part of banking has been profitable and virtually riskless, so at a time when return on equity (ROE) is running low this is significant. By contrast, peripheral banks have still had the ability to buy their own sovereign debt at levels above minus 40bp, so the problem has not been so acute for them. But with more and more Eurozone government debt yields falling below zero, this problem is spreading and the ECB is under pressure from the banks to provide some relief, especially if it intends on cutting rates again and making the spectre of a significantly extended period of negative rates a reality.

The outcome of tiering would be that a portion of the excess liquidity parked at the central bank will not be subject to the punitive negative rate. Exactly what rate might be charged, or on exactly what portion of the excess reserves the relief would apply to, is no doubt currently being modelled by the ECB in its usual forensic manner.

So at the margin this new measure of tiering would probably be good for banks’ earnings, but it is also potentially bad for Bunds and other deeply negative Eurozone debt, which is where the ECB faces a conundrum. Banks have been buying these assets as an alternative to parking cash at the ECB, but if parking at the ECB is not made more punitive by a further rate cut, or even made more attractive by tiering, then at the margin it would be bad for Bunds.

What can the ECB do about this? The next tool in the locker is a return to quantitative easing (QE), but the sequencing it has signalled so far has been a rate cut first (along with tiering), and balance sheet reopening second. Why put a policy through first that would put upward pressure on Eurozone government yields, only to then put through a new policy that re-anchors them? This does not make sense.

This is why the ECB has been busy modelling potential outcomes over the summer, and why we think Draghi and co. will need to announce QE (or very strong forward guidance at least) at the same time as announcing their rate cut in September, in the hope that QE trumps tiering as a driver of government bond yields.