Draghi caves but stops short of QE

After months of denial, it appears that the ECB has sat up and paid attention to the sluggish eurozone recovery and disinflationary pressures. 

Mario Draghi
Source: Bloomberg

The surprising decision to cut all main interest rates by 10 basis points caught the markets off-guard, culminating in the euro falling to a 13-month low against the dollar.

The ECB cut its main refinancing rate to 0.05% from 0.15% previously, but today it essentially manifested its commitment to its goals when it drove the overnight deposit rate deeper into negative territory, now charging banks 0.2% to leave funds with it, and cut its marginal lending facility – or emergency borrowing rate – to 0.3%.

The governing council agreed to use all unconventional measures at its disposal to hit its mandate – stable inflation at 2%.

While this might suggest that a quantitative easing programme is still possible, the decline in the euro and the diverging policies of western central banks would indicate that extraordinary stimulus of this nature will be kicked into the long grass for now.

Effect on the euro

The effect on the euro was immediately palpable as traders unwound long positions and initiated new short trades in the wake of the news. The single currency has fallen to a 13-month low against the dollar before, and seems for now to be setting around the $1.30 zone. This is something of a psychological level for the FX pair.

The ECB plans to buy securitised loans and broad portfolios of covered bonds in October, and they, along with the recently planned TLTROS, are expected to have a sizable impact on the ECB’s balance sheet. This is not quite quantitative easing, but may well appease markets for the time being and will have the effect of spurring riskier assets as investors chase yield.

Draghi’s aim

Though Mr Draghi has stipulated that the aim is to return the ECB balance sheet to 2012 levels – which is a sizeable figure of around €1 trillion but with lending still impaired – the wider impact of the move is perhaps uncertain, and the jury is still out as to whether this additional liquidity can meaningfully find its way to the broader economy.

Mr Draghi continues to insist that loose monetary policy on its own is pointless – it will only have the desired effect if accompanied by structural reforms and fiscal policy. If history is anything to go by, this will be another area fraught with procrastination among certain member states.

Impact on EUR/CHF

Most notably, the EUR/CHFEUR/CHF exchange rate, normally the drying paint of the FX world, is now being very closely watched for any breach of the 1.20 floor first put in place back in September 2011. The race to the bottom among central bankers is certainly not over – we can’t expect the Swiss National Bank not to intervene in a bid to protect its own sovereign and corporate competitiveness.

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