With an increasing number of market participants expecting a rate cut from the ECB at next week's May meeting, Goldman Sachs is piling on in a considerably less exuberant manner than the crash lower in peripheral bond yields would suggest. EURUSD reversed its gains very rapidly as Goldman slashed its growth forecast from -0.5% to -0.7%, expects a 25bps cut next week, but notes that this is "largely cosmetic" with few real implications for the economy. Critically, they also remind us that Draghi and his fellow ECB'ers have been increasingly stressing the limits of what the ECB can do - making it clear that it is local governments that must create conditions for the recapitalization of their banks. The point is, Goldman, like us, recognizes this is an insolvency (capital) issue not a liquidity issue, and it seems the ECB also knows that now. European stocks faded modestly on this as EUR sold off and peripheral bond spreads have ben leaking wider since yesterday as perhaps the reality is far less risk-supportive (via bond purchases?) than many had hoped.
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Via Goldman Sachs,
After the disappointing string of economic data over the past couple of weeks, we think the conditions set out by the ECB for a further easing in rates have now been fulfilled. We therefore expect a 25bp cut in the main refinancing rate at the May meeting, but no change to the deposit rate. We continue to view the rate cut as largely 'cosmetic', with few implications for the economy. The ECB still has room for manoeuvre with its non-standard credit easing measures. We also revise down our 2013 growth forecast for the Euro area, to -0.7% from -0.5% previously.
Disappointing April business surveys
The prepared statement from the ECB’s April meeting reflected a rising concern on the Governing Council about the economic outlook. In the opening paragraph, the GC states that “In the coming weeks, we will monitor very closely all incoming information on economic and monetary developments and assess any impact on the outlook for price stability.” During the Q&A part of the press conference, President Draghi then added “…we will assess all incoming data and stand ready to act.” Similar comments by other GC members in the following weeks have also clearly signalled, in our view, that a further weakening in the data would imply a rate cut.
The most recent data at the time were indeed indicating that the weakness was spreading beyond the peripheral countries and was affecting “countries in which fragmentation is not an issue”. The results of the April business surveys would therefore be of great importance for the ECB in deciding on its next actions. Given that the results of the surveys have been fairly disappointing, we now think the necessary conditions for a rate cut, as signalled by the ECB, have been fulfilled. Although the composite Euro area PMI was flat on the month and the rebound in the French PMIs was a genuine positive surprise, the overall balance of the April business surveys nonetheless highlights the risks to the ECB’s (and our) main scenario of a “gradual recovery” in the second half of this year.
A 'cosmetic' rate cut
As we have argued on several occasions, a cut in the MRO rate would have little impact on the Euro area economy. Funding rates for core Euro area banks are already close to zero. Only if the deposit rate were also cut would funding costs for core banks ease. As far as peripheral banks are concerned, the impaired transmission mechanism implies that the rate cut will not be passed on and that even if it is financial conditions for the private sector in the periphery would remain very tight.
Moreover, there is also a 'cost' that comes with a rate cut. We expect the deposit rate to be left unchanged owing to the “potential negative unintended consequences”, so the narrowing of the corridor between the MRO rate and the deposit rate would also lead to further disintermediation between banks. As peripheral banks would be able to refinance themselves more cheaply at the ECB, there would be less interaction with other banks. While it is not easy to assess the precise 'cost' of disintermediation, it is nonetheless relevant given that we think the positive effect of a rate cut is marginal.
Non-standard measures and the role of governments
Reducing funding costs in the periphery, despite signs of weakness in the core, should remain the ECB’s main focus. As Mr Draghi has said repeatedly, the Governing Council is thinking “360 degrees” on this topic. But Mr Draghi and other GC members have also increasingly stressed the limits of what the ECB can do on this front. If, for example, it is a lack of capital that is holding banks back from lending, there is not much the ECB can do. Rather, it is governments that would need to create the conditions for a recapitalisation of banks. We would expect the ECB’s demand for government actions to become even louder after a rate cut.
We downgrade our Euro area forecast
On the back of the latest data, we also revise down our Euro area growth forecast for this year, to -0.7% from -0.5% previously. The revision mainly related to growth in the first half of this year; we continue to expect a moderate acceleration in growth in the second half. More specifically, we now expect Euro area GDP to decline by -0.2%qoq in Q1 and then by 0.1%qoq in Q2 before stabilising in Q3 and then increasing slightly by the end of the year. The revisions are concentrated in Germany and Italy. In Germany, the rebound at the beginning of the year after the decline in Q4 last year, seems to be less forceful than we initially expected. Moreover, the latest business surveys out of Germany also suggest that the (moderate) momentum at the beginning of the year has started to slow again in Q2. That said, the fundamental picture remains sound, and we still expect a more lively rebound in activity during the second half.
As for the economic situation in Italy, we think both the credit crunch and political uncertainty are weighing on the economy more than expected. We continue to forecast a stabilisation in activity by the end of the year. This forecast, however, depends crucially on further non-standard measures from the ECB and/or the Italian government, which would improve the corporate sector's access to bank lending.