The news stream is not quite what the ECB had hoped. Money supply growth was weaker than expected, and credit extension to the price sector continued to contract. EONIA is elevated, climbing almost 7 bp to near 40.
This deterred banks from buying the short-term reverse repos that the ECB issues to sterilize the past sovereign bond buying for 24 bp annualized. The ECB intended on draining 172.5 bln euros, but the market only had the appetite for 103.9 bln euros. The gap appears to be the largest, so far. This is the third consecutive week that the ECB failed to sterilize the SMP purchases in full.
Separately, the ECB made a net injection of almost 51 bln euros in its seven day repo operations. Excess liquidity in the Eurosystem fell further yesterday to 86.3 bln euros. The combination of the sterilization failure and the net injecting in the 7-day repo operation may push excess liquidity back above the 100 bln euro level and pave the way for an easier EONIA after the turn of the month. Even then, a sustained move back below 20 bp may require some additional action by the ECB.
This elevation of EONIA seems to be a more pressing issue that disinflation, even after the small miss by the German HICP measure of April inflation. German inflation did bounce back in April, but by half as much as expected. The 1.1% year-over-year pace compares with a 0.9% print in March and a consensus forecast of 1.3%.
We had not placed much chance of unorthodox policies, like QE or a negative deposit rate in May. We suspect the pickup in inflation (tomorrow will see the flash April reading for the eurozone), will suffice. June would give officials time to get a clearer handle on price pressures and be informed by new staff forecasts. Our reading of the economic entrails and parsing of official comments suggests that a consensus for QE does not yet exist.
Still the ECB is likely to view the increase in EONIA as unwarranted. This suggests somewhat more orthodox measures, which could include a formal decision not to sterilize the SMP purchases, a token cut in the refi rate, and although few are talking about it, a cut in the 75 bp lending rate. Given the stress tests, we suspect that another LTRO would not be well received, and those that took funds would risk being stigmatized.
Separately, the European Banking Authority announced the adverse scenario that banks would be stress-tested for starting next month. It includes a 2-year recession and record level of unemployment (16%) across the euro area. To pass the test, the banks need to ensure that Tier 1 capital is at least 5.5% of risk-weighted assets.
Banks will also be required to model a deep selloff in equities, on par with crashes seen after the tech bubble ended and the fall of Lehman. In addition, banks will have to assume losses of their government bond holdings in their trading accounts (available for sale). The results are expected to be announced in October.
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