Opinions

ECB Preview: Going negative and beyond – 6 options for

Part 2: Draghi’s tools and potential reactions

6 Tools

1) Interest rate cut

A cut of the main  lending rate to 0.15% or 0.10%  will have a small effect on the real economy and is already priced in. The probability is very high, and this move will almost certainly be accompanied with a cut of the deposit rate.

2) Negative deposit rate

There is a high probability that the ECB will announce a negative deposit rate of -0.10% or 0.15%, at a value lower by 0.25% than the main lending rate. The actual figure makes less difference, but the actual move is of historic nature: the ECB will be the first major central bank to make such a moves. By “punishing” the banks for parking money with the ECB, the move is expected to make them lend out money to the real economy. A desired side effect would be that money would drive out of the euro-zone – lowering the exchange rate.

This is a big step. On one hand, the ECB has been talking about for over a year, announced it is technically ready long ago and it does not make sense to cut the main rate without cutting the  deposit rate. But on the other hand, the consensus about a cut in the  deposit rate is not as wide among  analysts as it is regarding the main rate. In addition, the actual announcement of a historic move could have a big impact. And most importantly,  money could gradually begin flowing out of the euro area.

All in all, it may be priced in for the short term, but could have a  significant negative effect in the long term.

Another opinion:  A negative deposit rate is not necessarily euro-negative

3) Dovish talk

In order to  secure a  successful announcement and a lower value fo the euro, Draghi will likely reiterate the forward guidance: rates could remain low for a long period of time, or even go lower. In addition, he could  explicitly hint of even lower rates and leave the door open to QE.

Markets are focusing on the steps  in the current decision and are not looking ahead at the moment. When the dust settles, a dovish stance, which seems quite likely, is probably not priced in.

4) FLS

The ECB could announce a plan of cheap loans to banks if and only if they lend out the money to the real economy. This has been done in the UK and would serve as a better targeted LTRO: loans that will that the ECB helps the real economy

. This has a medium probability. The actual impact depends on the scale: if it is in the hundreds of billions of euros, such a plan could weigh on the euro. If it appears just as an idea without a number, the  markets could ignore it.

5) New LTROs

The problem with the initial Long Term Refinancing Operations was that the money lent  cheaply by the ECB did not reach the real economy. And now, when banks are gradually returning the money, it creates a money squeeze. While a repeat of the program would not have a big impact, it could stop the current squeeze.

The probability is low. A new LTRO could only have a big impact on the euro is the scale is huge, in the upper hundreds of billions of euros.

6) QE

The ultimate tool that has been used in the US, the UK and Japan is  problematic for the euro-zone due to the nature of the union: it consists of 18 countries and monetary financing is forbidden. So which bonds will the ECB buy? Perhaps mortgage based assets? But how?

There are many open questions and many political obstacles, mostly coming from the conservative German Bundesbank. This option will probably be left for another day. If the ECB does announce outright QE, we can expect an immediate and a long term crash of the euro, but as mentioned, the probability is low.

Summary

  1. A  cut of the main lending rate has high probability and is already priced in.
  2. A negative deposit rate has a high probability, is partially priced in and is more likely to have a  long term negative effect on the euro. Without a negative deposit rate, EUR/USD could shoot back up towards 1.40.
  3. Dovish talk: has high probability, not really priced in, and would have an immediate negative effect.
  4. FLS: Medium probability, the impact depends on the size.
  5. LTRO: Low probability,  a huge size is needed for impact.
  6. QE: Very low probability, could have a huge negative impact.

At the time of writing, the trading range is between 1.3585 and 1.3650. Important lines to the upside are 1.3780 and of course 1.40. To the downside, 1.3475 and 1.33 stand out. For more, see the EURUSD forecast.

What do you think will happen on Thursday? Where will the euro end the week?

Here is the chart, click to enlarge:

EURUSD June 3 2014 technical analysis for currency trading forex sentimental outlook

(Back to part 1: background for the ECB decision)

Yohay Elam

Yohay Elam

Yohay Elam: Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I've accumulated. After taking a short course about forex. Like many forex traders, I've earned a significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I've worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.