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Draghi manages to exceed expectations

In today’s policy meeting and press conference the ECB took decisive action to loosen monetary policy. Although expectations were high, Draghi managed to exceed them by including a couple of measures that were not widely expected. As a result, financial markets reacted very favorably to the news.

In fact, after the initial reaction the intraday levels came very close to a ‘sell the rally’ signal based on overbought sentiment. Since then markets have retreated a bit but we think it is informative to mention that we are still operating from a ‘sell the rally’ perspective on financial markets and we are still very close to triggering a sell signal;

With respect to our business cycle score for eurozone equity today’s policy announcement nullifies one of the reasons we put the score on watch negative. The other reason, falling corporate earnings, is still a worry;

With respect to our view on core and peripheral bonds today’s policy action confirms our neutral stance on the former and our modest overweight stance on the latter. We still expect peripheral spreads to decline to 100bps from their current level of about 120bps;

With respect to our view on EURUSD we were expecting a final decline towards 1.07 – 1.08 on the back of the news, at which point we were happy to take any remaining overweight USD position off. Although there was a quick pop towards 1.08 the market has since bounced and currently trades around 1.10. From here we have low conviction in either direction and we therefore advocate a neutral stance;

In more detail the following decisions were taken:

(1) The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.

(2) The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.

(3) The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.

(4) The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.

(5) Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.

(6) A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.

Of these decisions the real surprise was in the announcement of TLTRO II and the inclusion of IG credit in the list of eligible assets. The cut in the deposit rate and the increase in the amount of monthly purchases as well as the loosening of the limits of how much the ECB can buy of a certain issuance were all expected to some extend (and in all kinds of different iterations);

The new four year TLTRO II program is very interesting. It will, as Draghi stated, clearly help banks with their long term financing. Also, with the incentives to lend embedded in the program it directly targets credit growth and therefore should help keep the recovery on track. Hopefully, it will also alleviate some of the concerns around the profitability of eurozone financials, although the cut in the deposit rate pushes in the other direction;

The inclusion of IG credit in the list of eligible assets is also a positive. It expands the scope of eligible assets considerably and it has the potential to directly lower companies’ funding cost.

Taking everything together this was really as much as we could expect and hope for. At the margin it will help support growth and inflation but probably does more for eurozone financial markets than anything else. Looking ahead, we think the ECB from here on can tinker on the edges but probably can’t meaningfully change the policy mix. For all intents and purposes it has shot its last big bullet, let’s enjoy it while it lasts.

Alain Zeitouni , March 2016

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