ECB will buy time in February

When the ECB meets on Thursday, it’s likely that monetary policy will be a secondary issue to bank liquidity and, most likely, the fate of the ECB’s holdings of Greek debt. The first two issues are linked; while the ECB has already been keen to separate liquidity provision from monetary policy, the fact is that the 3Y auction back in December has allowed overnight interest rates to fall substantially. We are currently seeing overnight rates trade by some 60bp below the 1% refi rate, similar to the discount prevailing in the early part of 2010 when the ECB’s 1Y repos were still outstanding. Still, in terms of funding costs for the banking system, this matters less now given that more banks are sourcing funds from the ECB rather than the market, with that cash remunerated at the average of the prevailing refi rate.

Of more interest will be the ECB’s stance on its substantial holdings of Greek paper (around the EUR 40bln mark) in light of today’s negotiations and the comments from the WSJ that the ECB may be looking to transfer its holdings to the EFSF. If that happens, no doubt some may round on the ECB for changing its previous stance of not participating in any restructuring deal. But, as we wrote last week in our blog (“The ECB will have to yield on Greece”), the ECB is doing the right thing and Draghi is adopting a more pragmatic approach than his predecessor. This is essential for a central bank and a monetary union both sailing through a crisis that neither was equipped to deal with. Markets are likely to welcome this approach.

On the economy, the ECB is likely to reiterate its position of last month, namely that whilst risks remain, there are signs of stabilisation overall. This should underpin its desire to hold rates steady and await the outcome of the second 3Y refinancing operation at the end of the month. The success or otherwise of this will be crucial in determining the extent to which the more bullish tone to markets carries through to the end of the current quarter.