Risk assets continue to rally on the prospect of central bank rate cuts and signs of progress on US-China trade negotiations. On Tuesday the Stoxx Europe 600 rose 1% and the S&P 500 gained 0.7%. On Wednesday the Shanghai Composite advanced by 1%.
The next significant event is tomorrow’s European Central Bank (ECB) meeting, and markets are pricing a 40% probability that it will cut rates. But while we expect the ECB to remove the tightening bias from its interest rate forward guidance and for President Mario Draghi to deliver a dovish message, we don’t expect rates to be lowered before September. Specifically we expect:
* The ECB to leave policy rates unchanged but prepare the ground for cuts in the coming months. We expect a 10bps rate cut on 12 September, with a further 10bps to follow on 12 December (or possibly earlier, on 24 October), rather than one 20bps reduction. The ECB has so far lowered rates in steps of 10bps below the zero interest rate mark. In addition, recalibrating the policy rate over a longer time frame allows the ECB more time for policy fine-tuning and means it will be easing for a longer time.
* Additional ECB interest rate cuts would likely further hurt bank profitability and bank loan creation. So we think that the ECB will implement deposit tiering to mitigate any such side effects, but will likely only announce this when it cuts rates. Tiering would reduce the increased cost of banks' excess reserves at the ECB's deposit facility. What's more, a lower ECB deposit rate will mean the forthcoming TLTRO III will become more attractive – which is the ECB’s main tool to encourage banks to lend.
* An effective quantitative easing (QE) program would require sovereign bond purchases, not just ABS (Asset Backed Securities) and corporate bonds. A new sovereign QE program faces significantly higher hurdles than interest rate reductions, in our view. A credible program needs to include a large purchase volume spread over a long timeframe. In 2015, the ECB committed to more than EUR 1tn of purchases over 18 months. Given the uncertain global trade environment, the risk is that such a program would be too large and / or too long. It would also likely require breaking either the capital key or the issue limit rules and could push bund yields further into negative territory. Given these drawbacks, we think that pressure would have to increase materially on the ECB for a fresh sovereign QE program to be launched.
The current environment remains positive for equities and low rates support carry trades, which help boost portfolio income. Euro investment grade credit spreads should also remain supported by an accommodative ECB. We expect the ECB to deliver markedly less easing than the Federal Reserve, shrinking the interest rate differential between the US and the Eurozone and supporting the euro versus the US dollar. We forecast EURUSD to trade at 1.15 and 1.17 over a six- and 12-month time horizon, respectively. We also retain some countercyclical positions to manage downside risk.