JPM: ECB Will Cut Key Rate to 0.50% and Deposit Rate to -0.25%.https://mm.jpmorgan.com/stp/t/c.do?i=11 ... h_-2tlkqf4
In early July, the ECB cut its main refinancing rate to 0.75%, prompting us to expect another 25bp cut in September. More surprisingly, the ECB also cut its deposit facility rate to zero, despite the potentially negative effects on market functioning. Having revealed a willingness to move despite such effects, we now think that the ECB will not shy away from cutting its deposit rate below zero. In terms of timing, we expect both the refi and deposit rate cuts in October, allowing the ECB a bit more time to assess any negative effects of the zero deposit rate before taking it negative.
The benefits of another rate cut
With peripheral banks reliant on ECB funding, the main benefit of cutting the refi rate by another 25bp is to reduce the cost of this funding for peripheral banks by another €2-3 billion over one year. This amount is not huge, but Draghi (surprisingly) cited it as one motivation behind July’s rate cut.
In terms of impacting market rates, cutting the deposit facility is more important. This is because the effective overnight rate (Eonia) is trading closer to the bottom of the ECB’s rate corridor due to the huge amounts of excess liquidity in the system. If the ECB cuts its deposit rate to -0.25%, Eonia would also decline below zero. This would then have the normal effects of a rate cut, e.g. on the term structure and via a weaker currency.
Finally, a negative deposit rate would lead to a ‘search for yield’. E.g. core banks would suddenly have to pay the ECB €2 billion or so per year on their excess reserves. In response, each individual bank may try to get rid of its excess reserves by purchasing positively yielding assets or by making loans. The excess reserves would not decline in aggregate, but they would circulate more quickly, with asset prices getting pushed up in the process. Even the zero deposit rate has had a big impact so far on shorter-term government bonds in France, Belgium, etc. And if Euro area politicians reduce the huge uncertainties facing the periphery, these reserves may even find their way back to the periphery, allowing peripheral banks to finally reduce their reliance on the ECB.