Will Draghi leave with a bang?

This week is all about Thursday’s ECB meeting as the US-China trade tensions have been benched until after the CCP’s 70^th anniversary on October 1. Consensus is aligning on three key measures to be implemented by the ECB, 1) deposit rate cut by -10 bps or -20 bps, 2) restart of Quantitative Easing with varying estimates on the monthly amount, and 3) tiering system for excess reserves. These aggressive measures are designed to stop the decline in economic activity that has hit the manufacturing powerhouse Germany the most. But will it work and how can investors play the ECB policy decision?

European banks to see repricing

When Japan entered into negative rates in January 2016 it introduced a three-tier system on excess reserves as its negative policy rate combined with quantitative easing would significantly increase the “penalty deposit tax” for banks. When the ECB introduced negative rates, it did not implement it with a tiering system as the ECB board was afraid that it would signal negative rates for a very long period. A tiering system allows banks to move their excess reserves created by quantitative easing from the deposit rate into a refinancing facility earning 0% instead of a negative rate.

Now consensus is expecting ECB to finally introduce the tiering system alleviating the pain for core European banks which sit on the majority of the €1.9trn in excess reserves. But will it help much? Japanese banks have done worse than European banks despite the help of a tiering system, so the tiering system does not change the long-term outlook for banks. But an ECB tiering system would ease core European banks of costs around €1-7bn depending on the size of the tiering system. This on the margin should lift valuations on core European banks. Our view is that investors could play this into the ECB meeting and capture the expected gains from a repricing. But our longer-term view is still negative on European banks.