Update 2: EURUSD now rising gradually as JC Trichet language in conference more hawkish than expected, although he does say the ECB did not decide hike was first in series.
- Trichet says rates across entire maturity spectrum remains low
- Says ECB did not decide hike was first in series
- Interest rate decision was unanimous
- Increasing CPI rates largely reflect commodity prices
- Upside risks to inflation outlook
- Medium term inflation outlook are on the upside
- Liquidity provision to be adjusted when appropriate
- Latest data confirms banks have continued to expand lending to private sector
- Positive lending flow becoming more broad based
- Inflation monitoring very closely
- Risks to economic outlook are broadly balanced
- Downside risks to growth from renewed tensions in financial markets, oil prices, protectionism, global imbalances
- Paramount that rise in HICP inflation does not lead to second round effects
Update: ECB Hikes by 25 bps as expected - No market reaction whatsoever: all telegraphed.
EURUSD post announcement: smallest swing following an ECB decision that we can recall:
2 Year Bunds:
Today at 7:45am EDT the ECB's Governing Council, which convened at 3 am, will announce its interest rate decision, which is expected by 76 out of 80 polled economists to be a 0.25% hike to the current rate of 1.00%. This will be the first rate rise since July 2008. Ironically, the decision to curb inflation will come hours after Portugal demanded a bailout: a development which will only be intensified by an interest rate hike. Zero Hedge will follow and announce the decision in real time, while the press conference following the decision which will provide clues about Trichet's future rate strategy can be seen here.
And some more on today's decision from Reuters:
The lights on 36th floor of the ECB's building, where the Council's meetings take place, were still burning brightly at midnight Frankfurt time following Portugal's call for aid.
The ECB is concerned that firm oil prices -- near 2-1/2 year highs -- could boost inflation expectations and financial markets are pricing in two further quarter-point rises in interest rates this year to follow a move on Thursday.
But the Frankfurt-based bank must be careful not to hurt the euro zone's struggling economies by jacking up rates fast and Trichet, who shocked markets last month by signaling an April hike, may not want to heighten expectations for further rises.
Bank-to-bank lending rates have already risen on rate hike expectations. The three-month Euribor rate has risen 25 basis points since the start of the year and hit its highest level since June 2009 on Wednesday.
The biggest paradox, as discussed yesterday, is that Europe is tightening at a time when more and more peripheral countries are in dire need of cheap capital.
"Typically, rate expectations move very quickly once the hiking cycle starts and I think Trichet knows the recovery is still quite fragile on the euro area aggregate -- the periphery is still struggling," said Nomura economist Jens Sondergaard.
"It's a tricky act for them. They don't want to signal that this is the start of a hiking cycle. On the other hand, I don't think they can be too complacent on inflation at the moment."
"The euro has rallied considerably on the ECB rate hike view but it may be the case of buy the rumor sell on the fact," said Koji Fukaya, chief FX strategist at Credit Suisse.
Indeed, the peak in the EURUSD may have been seen for this rate hike cycle.
Here's what to wach for during the conference:
Last month, Trichet dusted off the phrase "strong vigilance", which in the past signaled a rate rise was only a month away.
If, at Thursday's news conference, he omits a reference to rates being "appropriate" and says the ECB is monitoring inflation "very closely", markets will expect another rise in the coming months. But economists expect him to be coy.
The ECB may soften the impact of its key refi rate hike by leaving a subsidiary rate unchanged -- a move that will be closely watched to gauge just how nervous the bank is about inflation and how much pain it thinks the periphery can bear.
The ECB's overnight deposit rate, which acts as a floor for short-term market rates, could be exempted from the hike and left at 0.25 percent. This would make the refi rate rise largely symbolic; actual money market rates which guide the cost of bank borrowing might barely move.
An important issue that Trichet may have to dodge is when the ECB will phase out its offers of unlimited loans. These were introduced as an emergency step but have now become a liability, injecting so much money into banks that the ECB cannot effectively control market rates.
All will be revealed in T-minus 40 mintes.
For those interested, here is Goldman's prediction for today's events:
1. Interest rates: 25bp hike
Trichet signalled a 25bp hike at the first ECB Governing Council meeting in March and has since confirmed the Bank’s intentions at his mid-month Testimony before the European Parliament. March headline (HICP) inflation came in above expectations at 2.6%yoy (no details on components yet, but the largest rise came in Italy) and this is likely to strengthen the hawks’ case.
As Kevin Daly and I argued in last week's European Weekly Analyst, the risks to headline inflation are likely to influence the Governing Council, given the potential upward bias relative to the ECB staff’s more sanguine published forecasts. They could, therefore, lend less weight to the extent of excess capacity prevailing in a euro area where unemployment is still only marginally below 10%.
2. Wording adjustment to Trichet’s statement
If a rate hike does materialize, we would expect Trichet’s introductory statement to be ‘neutral’, though not dovish. We expect him to use the words “accommodative” (without “very”) and “vigilance” (without “strong”). In the first paragraph, the “upside risks to price developments” could stay too, but as an ex-post justification for the hike. Turning to monetary analysis, a slight change to the tone of the wording related to money growth would not concern us too much given that it has been benign so far. By contrast, if Trichet refers to “strong vigilance”, this would contradict his March signal that the April hike would not immediately be followed by a rapid hiking cycle).
3. The interest rate corridor: Possibly from +/-75bp back to +/-100bp
Beyond the decision on the level of the ECB’s main policy rate, currently at 1%, the Bank also has to choose the level of the two rates that de facto provide a cap and a floor to short-term money market interest rates. These rates currently stand respectively +/-75bp away from the main refi rate. The ECB is likely to decide to re-widen this corridor to +/-100bp, the width prevailing before the crisis.
This decision, albeit technical, would have important implications for EONIA. In the event of a re-widening, EONIA volatility would likely increase, but beyond the possibly strong initial upward impact of the hike, EONIA may not settle around an average that reflects the full hike over time. Two opposing forces will be at work:
- First, the "fixed rate full allotment" (FRFA) mode for all liquidity operations will remain in force until the summer, so market rates are still responding to the excess liquidity in the system: the tighter the corridor, the closer overnight rates are to the central refi rate (and vice versa) for a given quantity of excess liquidity.
- But, second, the punitive spread between the cost of liquidity at the refinancing operations and the remuneration at the deposit facility will be wider, thereby reducing the appetite for excess liquidity, at least at the margin.
4. Trichet will likely tone down the collateral stretch on Irish debt instruments
Following the publication of the Irish stress-test results last Thursday, the ECB announced the suspension of credit quality requirements normally applied to its liquidity operations for any debt instrument issued or guaranteed by the Irish sovereign.
In this way, the ECB ensured continuity, for all counterparts, in accessing normal central bank funding, rather than create ad hoc medium-term lending facilities that would be at odds with the ECB's general desire to normalise liquidity policy. Yet, the ECB may have to compromise down the line, because it is still not clear how “persistent” banks (those dependent on ECB liquidity), which will see the maturity of their funding mechanically shortened once the FRFA is phased out, will cope with it.
5. Market-wide liquidity: Normalisation in sight, but why not wait another month or two?
In terms of the loose FRFA liquidity procedure, and/or "new liquidity facilities" in the Irish context, we believe that the ECB remains committed to the normalisation of its liquidity supply and therefore that:
- The end of FRFA is in sight. Yet, we would be surprised to see it rushed through at this week's meeting. Many aspects of the sovereign crisis are still unresolved despite the European "March Summits" (see our European Views of March 12). Portugal faces potentially challenging funding deadlines this month and next, so it would seem hazardous to see the ECB move on too many fronts simultaneously.
- As for a new, medium-term, targeted facility that would provide bridge funding for (Irish) banks, it sounds generally at odds with the ECB's exit mode. If discussed at all, such a facility would likely face fierce opposition within the Governing Council, and it will take a lot of diplomacy and suasion for it to materialise. In this light, we believe that introducing some sort of case-by-case negative discrimination on specific assets and/or counterparties would be more in line with the ECB’s overall philosophy.