Outlook for the euro: ECB meeting and the 'nuclear' option of negative interest rates

The outlook for the euro is dominated by the ECB rate decision at 12:45 on Thursday - there is a general sense amongst market participants that the event will see no changes to the headline interest rates or policies. BUT - the danger lies in the mouth of Mario Draghi - what he says has the power to alter currency markets and move the euro.

"We believe that two items will make the press conference afterwards interesting: facilitating lending to small and medium sized firms (SME’s) and the issue of a negative deposit rate. Discussions on these issues will allow Mr. Draghi to show that the ECB has some bullets left to use if needed," says Piet Lammens at KBC Markets.

Camilla Sutton at Scotiabank says:

"Thursday’s ECB meeting is likely to see significant discussion on SMEs and the potential for negative interest rates. Today’s FT has an article that suggest the criteria for the ECB to ease lending conditions for SME’s has not been met and accordingly the central bank will back away from these strategies.

"We view this as EUR negative. However, on negative interest rates, there are several sides to this which make the FX impact confusing. If banks pass on the additional costs to clients then it would prove negative for the economy and weigh on EUR; how‐ ever if it encourages banks to pay down LTRO earlier than expected (and by so doing shrinking the ECB’s balance sheet) it could in turn prove fairly currency positive.

"We do not expect the ECB to turn towards negative interest rates. Instead we expect the central bank to prove slow to re‐ act, which will ultimately weigh on EUR. We hold a year‐end forecast of 1.25."

Shaun Osborne at TD Securities says:

"The ECB and the BoE meetings on Thursday seem to be shaping up to be bit sleepier than last month—particularly as expectations for more easing from the ECB have faded over the past week or so. An FT article from late yesterday suggesting the ECB is becoming less likely to use a ‘big bazooka’ approach to incent greater credit flow has further tamed expectations for what we might hear at Thursday’s meeting."

The possibility of negative interest rates? This is the nuclear option!

Piet Lammens says cutting interest rates to negative is the nuclear option available to the ECB:

"We still think that the chances of a deposit rate cut below zero are small, but they are not zero. It is a kind of nuclear option. A negative deposit rate coupled with a lower refi‐rate would reduce money market rates at the front end of the curve and could turn eonia negative.

"It would get round the zero rate bound. This will cost banks with large excess reserves at the ECB money. To avoid this, the central bank hopes banks will use this excess liquidity to buy higher yielding assets, to lend it in the interbank market, to buy government bonds or other assets, or to increase lending to businesses and households. It is unlikely that banks will use this excess liquidity to lend out more, as capital and not liquidity shortage is behind the cautiousness towards lending."