Where To Next For The EURO

The European Central Bank (ECB) will unveil today the outcomes of its comprehensive review of the operational framework designed to guide short-term interest rates.

This overhaul is a strategic response to the evolving financial landscape, aimed at enhancing the central bank’s ability to control money-market rates amidst a shrinking balance sheet.

A pivotal shift is anticipated as the ECB embraces a demand-driven system. In this new framework, the central bank aims to ensure that commercial banks maintain their desired level of reserves by providing adequate liquidity. This liquidity injection is expected to be executed through refinancing operations with varying maturities, spanning from short-term, possibly one-week, to longer durations, extending over a year or more.

Pricing strategies will play a crucial role, as the ECB seeks to minimize stigma, fostering a climate where banks feel encouraged to borrow the necessary amounts to stabilize interest rates at the intended level.

The cost of liquidity, a key determinant, is poised to decrease, approaching the deposit rate. Currently standing at a 50-basis point spread between the ECB’s Main Refinancing Operation (MRO) rate and its deposit rate, this adjustment aims to create a more favourable environment for liquidity participation.

Effective communication will also be paramount, with national central banks and regulators tasked with conveying the normalcy of regular participation in refinancing operations within a demand-driven system. The collateral framework will play a pivotal role in shaping the overall setup of liquidity provision.

The ECB’s liquidity-provision efforts are expected to be complemented by structural bond holdings, serving as a buffer against excess liquidity dropping below a predefined threshold. This portfolio is likely to include bonds of varying durations, excluding the longest maturities. A noteworthy aspect could be the inclusion of supranational bonds prioritized over national bonds, possibly extending to private-sector bonds. A “green tilt” in the structural portfolio would not be surprising, aligning with broader sustainability objectives.

A key post-quantitative easing (QE) challenge for the ECB involves a significant portion of excess liquidity being held by non-banking entities, including pension funds, asset managers, insurance companies, and corporate treasurers. These non-banks account for most unsecured transactions in the money market. The ECB faces the dilemma of ensuring that money-market rates do not fall below the system floor, potentially considering granting selected non-banks access to its deposit facility.

However, such a decision could have substantial implications for money market dynamics and benchmark rate calculations.

While the ECB’s minimum reserve requirement, currently set at 1% of specific liabilities (primarily customers’ deposits), is not expected to undergo significant changes, a small increase to 2% remains a possibility, albeit without high conviction. The ECB’s forthcoming decisions will undoubtedly shape the trajectory of monetary policy in the Eurozone, as it navigates the complexities of a post-crisis financial landscape.

Market commentary and analysis from Luca Santos, currency analyst at ACY Securities

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