Conventional and unconventional policies possible from the ECB

The ECB decided to keep interest rates unchanged at 0.25% as expected, but language from ECB President Draghi was dovish and suggested we may see the central bank take action in the next few months. Draghi highlighted the fact that prolonged low inflation itself is a risk, and said the governing council have had a detailed discussion about the possibility of negative position rates. Narrowing the rate corridor and quantitative easing were also measures that were mentioned, with the President claiming QE would need to be designed carefully in order to be effective. Some light was also shed on the strength of the single currency but it was emphasized that any action taken would not be targeted at the exchange rate. Draghi reinforce the fact that he does not see deflation risks in the eurozone, but with these options playing a greater role in ECB meetings, we feel the concern is becoming greater. 

The governing council felt more information was needed about the medium to long term inflation expectations before taking any action, but with different instruments tailored to address various issues it is unclear on what tool exactly the ECB is leaning towards. With the latest reading of 0.5%y/y surprising Draghi, the likelihood of invention in the next few months is increasing.

Sasha Nugent

Currency Analyst

Caxton FX 

The BoE may be able to keep rates low after all

Today’s inflation figure shocked the market, and has further dampened expectations that the Bank of England may need to raise rates sooner than outlined in forward guidance. CPI came in at 2.2%y/y, the lowest level since September 2012, with the deceleration attributable to lower transport costs and education costs. The pound took a beating post release with GBPUSD dropping to 1.5850 and GBPEUR dipping below 1.1850.

The central bank will publish their updated economic forecasts tomorrow, and in the light of today’s inflation reading, we could see inflation projections revised downwards. In forward guidance, the BoE committed to keeping rates low at least until unemployment was below the 7% threshold, despite above target inflation. With price pressures easing, and the economy improving, there no immediate need to raise rates, and the central bank now has more room to keep policy loose in order to continue to support the recovery.

The market had previously questioned whether the BoE will be able to keep rates low, but with inflation now at 2.2%y/y, pressure on the central bank has eased. What needs to be highlighted is that once energy prices take effect, the decline in the inflation rate is likely to be reversed and the road to achieving price stability will be more difficult.

Sasha Nugent

Currency Analyst

Caxton FX

What can we take from the RBA minutes?

Last night’s Reserve Bank of Australia minutes were unsurprisingly dovish given the downturn in Chinese and global growth over the past few weeks and months. The minutes explained the key drivers behind the central bank’s decision to cut interest rates at its meeting earlier this month. As well as slower growth in Asia, lower commodity prices and weaker domestic growth also topped the RBA’s list of concerns. The bank is now envisaging a peak in resource investment, sooner and lower than initially estimated.

An ongoing decline in coal coking prices is alarming the RBA and there are reports of early closures of older mines and low take-up of new resource projects. The mining boom has been a huge driver of Australian growth in recent years and these tell-tale signs of decline are bad news for the economy and the AUD as a result. Weakening demand from the eurozone is clearly taking its toll on Chinese growth and the knock-on effect is weaker demand for Australian commodities.

The RBA is also very concerned about the aussie labour market. We have had a decent Australian employment update this month but the unemployment rate has climbed up to two-year high of 5.4% and the central bank is anticipating a deterioration in the coming months, in no small more part due to projected mining sector weakness. The mining sector has masked underlying weakness in the labour market for a while now, the truth should now emerge. 

Australian Treasurer Swan indicated last month concerns over a fall in Australian tax receipts, while the Government is committed to returning to a budget surplus. The difference is being made up in budget cuts, which will also weigh on Australian growth in the coming months.

Amid all these downside risks to Australian growth and the noticeably dovish tone in these latest RBA minutes, we are expecting another interest rate cut at the RBA’s next meeting in November. October 24 brings a key quarterly Australian inflation figure but an upside surprise does seem very unlikely and the path should be clear for another rate cut. This leaves plenty of scope for AUD-weakness in the coming weeks and months. 

Richard Driver

Currency Analyst 

Caxton FX

Will the ECB cut interest rates next week?

Away from what’s going on in Spain and Greece, let’s take a look ahead at next week’s ECB meeting. This week’s key German business climate figure was awful and the significance of this will certainly not have been lost on the ECB. With economic contraction throughout the periphery weighing on growth in the eurozone’s powerhouse economy – will the ECB finally put its deeply engrained fear of high inflation to one side and give Germany and perhaps more importantly the rest of the eurozone a helping hand by lowering interest rates?

A German contraction in Q3 is not a certainty but it is now looking likely, particularly in light of the latest German confidence figure, which hit its lowest reading since March 2010. Spain’s central bank warned yesterday that its economy’s GDP continued falling at a “significant rate” in Q3, while S&P forecasted that Spanish GDP will contract by another 1.4% in 2013 and the eurozone economy a whole will achieve zero growth. With conditions so dire in Germany’s major eurozone trading partners, you don’t have to dig too deep to find motivation for a rate cut.

Domestic consumption, which accounts for around 60% of German GDP, is in good shape and consumer confidence remains stable. Admittedly, other domestic German indicators such as the ZEW and PMI surveys also suggested things are not so bad but we can probably put this down to temporary positivity triggered by the ECB’s bond-buying plan. The German business climate survey has built up a strong correlation with German GDP, which leads us to believe a Q3 contraction is on the way. Weak exports are likely to outweigh robust domestic demand.

Still, the ECB seems unlikely to cut interest rates next week. The ECB appears to have already factored in further weakness in eurozone growth; recently projecting a 2012 GDP contraction of between -0.6% and -0.2%. This latest poor figure from Germany probably does little to change the ECB’s approach. Indeed Draghi acknowledged a weaker business cycle in his September ECB Press Conference.

In addition, the ECB’s Nowotny has recently stated that he “sees no need to change interest rates in the eurozone currently.” ECB policymakers have also been lauding the positive response in the financial markets to the ECB’s bond-buying plan, suggesting they are satisfied with the 0.75% interest rate at present. Draghi will also be eager to keep the German ECB policymaker Weidmann on side by waiting until a rate cut is absolutely necessary, when German growth has completely ground to a halt and inflation has eased further. This is likely to happen later on in Q4, perhaps in December. The euro is certainly feeling the pressure at present but it will likely be spared the downside factor a rate cut for the time being.

Richard Driver

Currency Analyst

Caxton FX

Caxton FX Weekly Round-up: Euro takes a hammering

ECB cuts rates and the euro takes some punishment

The ECB met expectations last week by cutting the eurozone interest rate to 0.75%. In addition, the deposit rate was cut to zero. This all makes the euro the second-lowest yielding currency in the market after the swiss franc, which is likely to see investors increase their use of the euro as a funding currency for carry trades into higher-yielding currencies. This should be a major factor weighing on the euro moving forward.

For many, the ECB’s rate cut did not go far enough in offering support to the eurozone’s deteriorating situation. There is a significant chance of another interest rate cut at the ECB’s next meeting in August, as there is of alternative easing measures such as another LTRO (cheap loan offering).

The post-EU Summit optimism has well and truly run its course and the market sentiment has once again turned negative. Spanish bond yields are back up at 7.0%, while global equities have tumbled for three days straight. Eurozone investor sentiment data was very poor on Monday morning and with the market already reflecting on recent weak data from the US, Japan and China, the euro has come under some pressure.

It is not all bad news for the euro, however, as we have heard today that Spain will be granted a year’s grace until 2014 to meet its deficit target of 3%. This has been insufficient to trigger any major euro bounce, which is sitting close to 3 ½ year lows against the pound and 2 year lows against the USD.

US data spooks market and risk aversion takes hold

The key monthly figure from the US labour market disappointed last Friday. It is always interesting to see how the US dollar reacts to weak domestic data and Friday’s installment proved supportive of the greenback. Dollar-friendly risk aversion was the knee jerk response, despite the fact that the downtrend in US data is likely to push the US Federal Reserve into finally pulling the trigger with regard to QE3 later this year. There is a chance that the Fed will do so on August 1st and much depends on US data in the intervening period, but we suspect Ben Bernanke & Co will choose to keep their powder dry for another month at least.

The flight to the safety of the US dollar has seen GBP/USD lose some ground in the past few sessions. The Bank of England’s decision to inject another £50B of quantitative easing into the UK’s flat lining economy was broadly priced in, though last week’s poor growth figures from the UK’s construction and services sectors in particular were not helpful for GBP. The week ahead is fairly quiet in terms of domestic data, with only manufacturing production data and trade balance data likely to receive much attention.

EUR/USD was last week’s major mover, having tumbled from above $1.26 to below $1.23 in the space of just three sessions. We have been calling for a slide down towards and below $1.20 and this latest euro sell-off has only strengthened our resolve. GBP/USD fell as well, but not by as much (it fell from $1.57 to $1.55). This cleared the way for GBP/EUR to help itself to some easy gains up above €1.26. These are clearly strong levels at which to buy the euro in the short-term, though in the longer-term we target levels even higher in the direction of €1.30.

The market will look to the meeting of EU finance ministers over the next two days for a decision to activate the buying of peripheral EU debt but as ever there remains plenty of scope for disappointment here.

End of week forecast
GBP / EUR 1.2625
GBP / USD 1.5475
EUR / USD 1.2250
GBP / AUD 1.53

Richard Driver

Analyst – Caxton FX
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Interest rate cut seems inevitable as the ECB looks to ease the debt crisis

The Governing council meeting of the ECB is set to meet in Frankfurt on Thursday and it is widely expected that it will produce the decision to lower its interest rate. It is a measure of the eurozone’s poor debt and growth dynamics that the ECB interest rate has already been cut to its current record low 1.00% level from its August 2008 level of 4.25%.

Clear indications have been made that the ECB is looking to cut the base rate. ECB Chief Economist Peter Praet has stated in the past week that “there is no doctrine that interest rates cannot fall below 1 percent…they (rate cuts) are justified if they contribute to guaranteeing price stability in the medium term." These comments followed others from another ECB policymaker who stated that a rate cut was an option that would be discussed in its July meeting. In light of this rhetoric, the market is rightly confident that another emergency cut will come from the ECB on Thursday.

A rate cut should come as no surprise given the prevailing conditions in the eurozone. Data this week has revealed that eurozone unemployment has hit its highest ever level of 11.1%. Growth data from the eurozone, including Germany worryingly, has been consistently poor and it is quite clear that the region had re-entered negative growth. Q2 could actually prove to be the worst quarterly growth performance in three years.

Eurozone inflation has also eased significantly this year, falling to 2.4% from the 3.0% level at which it ended 2011. Germany has always been obsessed with controlling inflation but even it must have softened its stance on loose monetary policy in light of the news that its domestic inflation rate eased more than expected to 1.7% last week.

There are plenty of doubts surrounding the impact of another interest rate cut. The Bank of England has decided not to cut interest rates despite entering a double-dip recession, precisely because of the limited impact that such a move would yield. However, a rate cut would translate into significant savings on the huge amount of loans that European banks have taken from the ECB over the last year.

There is the argument that a rate cut will actually undermine confidence as the ECB is seen to be desperately exhausting its options, but we reject this. Our view is that a rate cut will actually be welcomed as a piece of assertive action amid growing eurozone turmoil, though the reduction of the euro’s interest rate differential will stop this boost in confidence resulting in any material support for the euro.

It goes without saying that a rate cut will not solve the problem in the long term. The financial crisis in the Eurozone has come about due to structural problems, and as such, the solution must involve structural change. Lowering interest rates is not capable of fixing this crisis. In fact as ECB President Draghi has noted, long-term solutions to the debt crisis are in the hands of the EU’s political leaders, not its central bankers. The ECB can only really ease conditions in the short-term, as shown by the two rounds of cheap loan offerings in the past year or so (LTROs).

There are differing views on just how much Draghi & Co will cut the base rate by and the size of the cut is likely to impact on the market response. A 0.25% rate cut may not be enough to satisfy the market’s appetite for emergency measures. A 0.50% cut is possible but a quarter percent cut seems more likely, with the ECB declining the options of another cheap loan offering or bond-buying.

Adam Highfield
Analyst – Caxton FX
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