In the last post, we went from Danske bank’s interpretation of a two tiered system of interest rates in Europe to my own investigation, explanation and implications. The problem with the Two Tiered scenario is its not only wrong but far off the mark. Again,we have banks and analysts putting out PR documents without proper analysis just to show they are the first with an appearance that they are the smartest person in the room. I fault myself to not apply more critical analysis.
We have to think of a central bank purpose and that is to foster Lend and borrow in economies while managing the money supply. In hindsight, I’m not sure a Two Tiered system and add another interest rate in the mix is reality since the interest rate corridor compresses in Europe but think of the implications in this scenario for Denmark, Norway, Sweden, Switzerland and East European nations. A two tiered system is a wholesale change, central banks rarely institute major changes. What we saw from the Draghi cut was typical gradualism.
Prior to the Draghi cut, the interest rate corridor was 25 basis points between Eonia and the Main Refinance Rate and 50 basis points for the entire channel from Eonia to the Marginal Lending Facility. The corridor was balanced at 25 basis points from Eonia to the Main Refinance Rate and from the Main Refinance Rate to the Marginal Lending Facility. Libor to Eonia was 1 basis point wide, 24 basis points from Libor to the main Refi rate and 49 basis points from Libor to the Marginal Lending Facility.
After the Draghi cut, Eonia to the Main Refi rate now contains a 35 basis point corridor and 25 basis points from the Main Refi rate to the Marginal Lending Facility. Its a 35 and 25 basis point corridor and 60 basis point total. Libor to Eonia is now 10 basis points, Libor to Refi 25 and Libor to Marginal Lending 50 basis points. The current channel is 60 basis points vs Libor 50. But Libor to Refi is 25 and 35 from Eonia to Refi. Libor will begin a slow drift downwards. Libor dropped 1 full basis point from Wednesday’s cut to current.
Draghi expanded and extended QE. Here’s where the Two Tiered system was a lost proposition. Draghi needed the extra 10 basis points channel from 25 to 35 to allow more volatility inside the channel to vary his bond purchases inside the range. Forget QE under an added interest rate and compressed channel and forget time expansion.
The current EUR/USD price at 1.0879 trades below Libor and all European interest rates. The big points from current price above are found at 1.0995, 1.0932 and 1.0902. The top of the Libor channel is found at 1.1632. For EUR/USD to hit Goldman’s 0.9500 target then Libor and Eonia must see the deposit rates at -0.20 and -0.30. Long way to go.
Volatility from December 1 – 4 ran 2.0 annualized and 1.8 daily. December 1 – 2 volatility ran 2.3 annualized and 2.1 daily. December 2 – 4 volatility dropped from 2.0 annualized and 1.8. The warning for the massive rise was seen from December 1 -2 as volatility and price share an adverse relationship. 2.3 dropped to 2.0.
Constancio from the ECB stated the market misunderstood implications for the cut. The market actually got it perfect as the EUR/USD was at dangerously low levels and seen from volatility and interest rates. The timing of the cuts came at the Bottom of the Eonia channel. The ECB in my observation believed the EUR would see a massive drop instead of massive rise. Who am I to go against a central bank voter.
M 1 increased October to 11.8% from 11.7% September and broader M3 increased to + 5.3 from 4.9% September.