FT Alphaville " On a negative deposit rate at the ECB Before this month's ECB interest rate policy decision, a number of analysts had come to think that the ECB might be inclined to adjust its so-called rate corridor. The corridor is best explained as the difference between the discount rate (or deposit rate) and the central bank's most punitive rate, the marginal borrowing rate in the case of the ECB. As RBC Capital's analysts noted before the decision: While we expect the ECB to lower the refi rate, we do not expect them to reduce the discount rate. As such, the corridor around the refi rate is likely to fall to 100bp from 150bp at the moment (deposit rate 0.25%, refi rate 0.75%, marginal borrowing facility 1.25%, from 0.25%, 1.00% and 1.75%, respectively). We see three reasons why the ECB is unlikely to change the deposit rate for now: Very little liquidity actually transacts at EONIA (average volumes around €30bn). With the ECB currently lending €835bn at the refi rate to the market, the amount of liquidity trading at EONIA is dwarfed by the ECB. While the deposit rate does put an effective floor under EONIA, the deposit rate is not acting as a barrier for the richening of German paper, the transmission mechanism into peripheral paper from lower rates is working to a degree. Given the heightened systemic risks, lowering the cost of liquidity insurance and the penalty for liquidity shortfalls is probably good precautionary policy In other words, the analysts felt that if the ECB was to move, the move would be staggered...and mainly focused on the refinancing rate and the marginal borrowing rate. This is largely because a zero-rate (or negative) deposit rate has the potential to become a bit troublesome. Of course, we now know that the ECB did not change its rate policy. But were the RBC analysts wrong in their assessment or were they possibly just too early? Cue last week's analyst report from Morgan Stanley's rates team, which notes that market rates, if anything, are pricing in the RBC view. As they noted on January 20: EONIA forwards reflect expectations that the Deposit rate will stay at 25bp. But on our calculations, they don't adequately reflect the possibility the Deposit rate will fall to zero or even into negative territory. Hence, we recommend receiving June EONIA ECB forwards, and going long June EURIBOR via risk-reversals expiring in April. The MS analysts themselves are of the belief that this is wrong. Eonia forwards are mispriced. They think that if and when the ECB moves, the entire rate-complex will be hit. That includes the deposit rate, which would most likely hit zero if not negative territory. According to the MS analysts this makes sense, since a zero-rate or negative deposit rate could encourage interbank and real economy lending rates to fall. Pooh-poohing the RBC analyst notion completely, they note the following: ...Depo Cuts Are More Likely However, cutting the Refi rate without cutting the Deposit rate won't achieve as much as it should, because the Deposit rate puts an effective floor on EONIA and, by extension, on EURIBOR and on effective lending rates in the wider economy (Exhibit D1). Therefore, we reckon that further Refi rate cuts should be accompanied by a further reduction in the Deposit rate to 0%, or even into negative territory, to: 1. lower the cost of money; and 2. incentivise the banks currently parking their excess liquidity at the Deposit Facility to increase their interbank and private sector lending. To this point, it's notable that ECB President Draghi said explicitly at the February press conference that the banks taking liquidity at the various Refi operations are not the same as those using the Deposit Facility. Such a cut in the Deposit rate, and therefore in EONIA and other financing rates, would also pave the way for a monetary policy justification for full-blown QE - as all other monetary policy options would have been exhausted. Our economists expect the ECB to move to full-blown QE in summer. Which means Eonia forwards as they stand now may be mispricing the risk of zero or negative deposit rates. If the Deposit rate is cut to 0%, we would expect EONIA to move to 0.10-0.12%, ie a fall of 18-20bp. Conversely, we think the chance of EONIA trading substantially above 0.35-0.37% is small. ...or, perchance, they're indicating that the market would really prefer the deposit rate not to fall? Related links: The curious case of ECB deposits - FT Alphaville Just to be clear about those those ECB deposits... - FT Alphaville On the perils of plunging repo rates - FT Alphaville This entry was posted by Izabella Kaminska on Wednesday, January 25th, 2012 at 16:15 and is filed under Uncategorised. Tagged with Deposit rate, ecb, interest-rate corridor.