ECB (In)Decision Preview
Today the ECB is expected to do absolutely nothing, although many have their hopes up that at the post announcement press conference Mario Draghi may possibly hint at some more easing (with what collateral we wonder, and with what Germany) to bring some spring into the step of a continent that has milked $1.3 trillion in 3 year repo/discount window borrowings for all their worth and then some. And instead if the ECB cuts its rate below the psychological barrier of 1% today, or at any time over the next several months, it will make Hugh Hendry once again that much richer. Recall as of November: "He’s made bets that he says will deliver a 40-to-1 return if the ECB cuts rates below 1% next year." Below is a full rundown of what to expect, and not to expected, from the former Goldmanite, now head of the central bank for the world's biggest economic region.
José Manuel García-Margallo (Spanish Foreign Minister) - “This is like the Titanic. If there’s a sinking here, even the first-class passengers drown”
It is widely expected that today’s meeting will lay foundations for another round of monetary policy easing in June when the governing council will be provided with a new set of macro economic forecasts. However, it is unlikely that Draghi will explicitly state the tools that the central bank will turn to next, but instead, will reiterate that all options remain on the table, including the use of the dormant SMP.
As such, close attention should be paid to the opening remarks by the President, where a shift in the language away from inflation targeting to supporting the fragile peripheral Eurozone, together with a potential reference to extremely high uncertainty, may prompt speculation that another “bazooka-like” program will be announced. In turn, an aggressive retracement in the peripheral bond yield spreads in respect to the benchmark German Bund will likely take place, while the financials sector will most likely end up as the biggest beneficiary in the equity space.
Furthermore, Draghi may imply that unlike other major central banks which slashed interest rates to near zero level, the ECB still has leeway to reduce borrowing rates further. The fact that another rate cut is not yet priced-in gives reason to believe that a statement of this nature may have a more pronounced effect on broad market sentiment than a hint that another LTRO may be employed. A number of ECB members voiced their concern over the use of the LTRO and another rate cut, especially at the time when banks are eagerly awaiting the outcome of the latest Moody’s review of the EU banking system should in theory enable easier and cheaper access to various credit markets. This should be most evident in a lower EUR basis swap rate, further reduction in the daily Euribor fixings, as well as the LIBOR rates.
From Bank of America:
No imminent move on rates expected
The downturn in recent macroeconomic indicators is likely to have been welcomed by the ECB but we do not believe that it will react to just one month’s set of data. Likewise, markets look beyond the stress levels that have prompted the ECB to act in the past. Hence, we believe that Mario Draghi’s speech on Wednesday may strike a more dovish tone but not signal any move.
That said, we believe the ECB will continue to monitor the situation and various macroeconomic and market stresses very closely. We review here the ECB’s potential options in turn and the conditions that might prompt the bank to make certain moves. We believe it is most likely to lower interest rates if the macroeconomic outlook is further weakened by a contraction in credit demand and the return of sovereign tensions. The ECB is unlikely to initiate a further LTRO until euro area banks are appropriately recapitalized (or suffering financial stress akin to that of November 2011), even if sovereign tensions were to increase in some countries.
The arguments for and against interest rate cuts
For: Macroeconomic outlook worsens in line with BofAML projections
The ECB may face the worst dilemma for a central bank: weakening GDP growth when inflation is not receding fast enough to warrant a swift rate cut. Against such a backdrop, the ECB has two arguments for lowering rates: it has not yet factored in a recession but, if there is one, it is likely to accelerate the inflation decrease. Despite the recent LTRO, credit demand has dropped sharply since the beginning of the year: together with weakening indicators and some renewed sovereign stress, the economic outlook might deteriorate beyond the ECB’s current projections.
Signs of deteriorating economic conditions suggest that the ECB could revise its macroeconomic projections downward. April indicators have weakened (notably the PMIs). More importantly, the ECB’s latest lending survey showed a sharp decline in demand for credit. This confirms our view that investment across euro area countries, but especially the South, is likely to continue to weaken. Compared with the last ECB projections, fiscal adjustment has possibly been delayed somewhat in some countries but the credit outlook is likely to have deteriorated further. For the moment the ECB is projecting 2012 GDP contraction of 0.1%; taking the above factors into account, the ECB could revise this downwards (our own projection is that economic activity contracts by 0.5% this year).
In our view, the ECB would require confirmation of weakening indicators and need to change its growth outlook to be in a position to signal a rate cut. The bank’s next round of macroeconomic forecasts is due in June, followed by September. Should the data continue to weaken in line with our macroeconomic scenario, we could see a revision to the ECB’s macroeconomic outlook as soon as June if financial market stress persists. This would be the opportunity to start signaling rate cuts later in 3Q. In addition, the ECB is likely reluctant to move before the political process to approve the ESM, the fiscal rules and the euro area structural reform package (the so-called six pack) is complete by July. Once this political process is done, the ECB could justify further loosening if needed. In the meantime, the ECB will likely just continue urging the politicians to do their job. A rate cut before the summer is therefore unlikely, in our view.
Against: Current and future inflation in some euro-area countries
In our view, rates are already too low in some euro-area countries, so further cuts could risk sparking off inflation. We would argue that what matters is inflation for the euro area as a whole, which is set to decelerate to 2% towards the end of this year or beginning of next year. Individual countries with higher inflation rates do have other tools at their disposal (fiscal policy, supervisory and regulatory policy) to keep inflation at bay. That means there can be countries with higher than euro average inflation and others with below average inflation. That said, inflation is going down very slowly across euro-area countries, and fiscal adjustment in the form of tax hikes and increased administered prices also hamper disinflation.
LTRO: Not before banks are appropriately capitalized
The December LTRO did much to allay the concerns of the financial markets, but we would argue that this remains a special tool in the sense it should only be used under specific circumstances. The ECB’s first two LTROs were designed to address bank illiquidity and buy time for them to strengthen their capital base and for governments to support the capital-raising efforts of their domestic banks if and where needed. With the LTRO program, the ECB has acted within the limit of its mandate as a lender of last resort for banks. Subsequently, there has been some concern inside the central bank that the ECB’s balance sheet has increased too much as a result of the LTROs.
Lower collaterals unlikely as a tool to support bank funding at euro level
Clients have often asked about the possibility of reduced collateral or equivalently lower margin requirements by the ECB should liquidity again become a problem. In our view, the latest extension of collateral being conditional on national central banks bearing the risk is a sign that the ECB is unlikely to move in that direction.
In December 2011, the ECB allowed national central banks to take on risks by providing liquidity to their domestic banks in exchange for country-specific collateral. This was with the proviso that the associated risks would remain supported by national central banks and not be consolidated at the euro-area level. Given the public discussion by ECB members on the risks taken by the bank with the LTRO, and the flexibility granted by the ECB to national central banks in terms of collateral management, we do not believe the ECB is likely to modify its own collateral requirements to accommodate some banks in specific countries. As we argue above, the ECB is now urging governments to strengthen their domestic banking sectors. Should some institutions need emergency funds, it will be up to national central banks to provide support by using the framework for collateral designed in December 2011 (see the ECB press release published in February here).
And Finally, a compendium of sellsider views, courtesy of Bloomberg:
- Central scenario is ECB will keep policy rate unchanged, case for rate cut is growing, Evelyn Herrmann writes in note
- The complacency at the last press conferences is likely to have been rattled by weak growth and mkt wobbles
- Press conference should be more dovish than the last
- If Draghi doesn’t mention inflation issue in his introductory statement it will be a dovish sign; looking for hints to the direction of staff forecasts
- If the weak dataflow continues, a rate cut as soon as the next review of the ECB’s staff projections can’t be ruled out
- To justify current valuations, ECB would have to deliver rate cuts in coming months, Christoph Rieger writes in note.
- While Draghi should keep all options open, these ambitious market expectations harbor risks for a setback today
- Convinced ECB won’t cut its deposit rate, rendering EONIA forwards too low; a cut in refi rate seems possible later this year
- With inflation still high and political claims on ECB getting more vocal, sees no rate change, “would also be surprised if Draghi were to flag a rate cut”
- Look for ECB to keep rates on hold for fifth consecutive month, Jennifer McKeown writes in note.
- While acknowledging economic outlook has deteriorated, Draghi seems set to argue ECB has already done enough by providing ample liquidity to region’s banks and cutting interest rates to record lows
- Draghi likely to call for govts to act to restore markets’ confidence themselves, and say ECB won’t take further steps to finance their deficits for them
- Markets are still convinced ECB will do nothing NT; continue to hold out hope the ECB eases, Marchel Alexandrovic writes
- If there isn’t a cut it will be important to see whether Draghi prepares markets for a June move by flagging the downside risk to ECB staff projections
- ECB should stick to its wait-and-see stance; worsening economic picture suggests a more cautious tone on growth outlook and no pre-commitment, Marco Valli writes in note.
- Expects speculation about reactivation of SMP to come to nothing; General Council to show unanimous position on no need for SMP intervention
- Don’t expect a significant decision on rates or operations, note says.
- Draghi’s comments on April 25 suggest a more cautious assessment of euro-area growth prospects, likely to prevail in the introductory statement and subsequent Q&A session
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