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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Caxton FX Weekly Round-Up: GBP/EUR/USD

ECB loans fail to deter euro reversal

The European Central Bank’s second LTRO, in which it offered more three-year loans at 1.00% to the eurozone’s struggling banking sector, failed to give the euro the impetus to build on gains it has made in the year to date. The cheap loans have been crucial in avoiding a credit crunch and bringing down peripheral bond yields in recent weeks. Risk appetite has been booming in as a result but it seems unlikely that this second LTRO, of which demand was similar to last December’s, will have the same impact. The market saw fit to use the event as an opportunity to take profit on the euro’s strong start to 2012 and the single currency sold off across board.

The Greek issue continues to peg the euro back. A debt-swap deal must emerge by Thursday evening. Failure to persuade enough private bondholders to accept losses of at least 53.5% on their holdings could result in credit default swaps being triggered and a whole wave of financial turmoil. In addition, Greece’s second bailout still hasn’t been signed off and a U-turn remains possible. Greek nerves are likely to steadily build this week.

Concerns outside of Greece have also added to the weight being felt by the euro. Spain has defied the EU by setting a softer deficit target than that agreed under the recent fiscal compact (5.8% rather than 4.4% of GDP).

Economic growth is at the heart of this problem – these countries are struggling to cut their debt because austerity measures are strangling output. Recent data revealed that the pace of contraction in the eurozone services sector quickened in February, while unemployment increased.

February’s growth data suggests firm Q1

The pace of growth in the UK manufacturing sector slowed in February. The same is true of the UK services sector, while in the construction sector we saw the best monthly posting since April 2011. Still, the market’s key concerns focus on whether the UK will head back into recession, whether the MPC will announce further quantitative easing, and whether the UK will lose its AAA credit rating. The growth data from January and February has balanced the risks in favour of a ‘no’ to all of these questions. As such they should give sterling some underlying support in the coming weeks.

Ben Bernanke indicates QE3 is off the table

A speech from US Federal Reserve Chairman brightened the prospects of the US dollar last week. Bernanke failed to a make any reference to “QE3” – a third programme of quantitative easing. The market took this as a ‘clear’ indication that the upturn in the US economy in recent months has caused the Fed to step away from the option of more QE. Bernanke’s ‘signal’ could well turn out to be the catalyst for the US dollar to reverse the weakness we have seen in the greenback in the first couple of months of this year. Data last week confirmed the reason for optimism with regard to the US, revealing that its economy grew at an impressive annualized pace of 3.0% in Q4 2011.

Sterling is trading back up at €1.20 now, thanks to the euro’s poor end to last week. Risks remain to upside ahead of the tensions that will inevitably build as a result of the ongoing Greek debt-swap negotiations. We continue to hold the view that with GBP/USD up at $1.5850, this is a strong level at which to sell sterling and buy USD.

End of week forecast
GBP / EUR 1.2075
GBP / USD 1.58
EUR / USD 1.31
GBP / AUD 1.49

Richard Driver
Analyst – Caxton FX

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