ECB President Draghi calms market fears by pledging the ECB will do “whatever it takes”

The president of the European Central Bank, Mario Draghi, has asserted this morning that, within its mandate, “the ECB is ready to do whatever it takes to preserve the euro, and believe me, it will be enough.” He added that the solution was “more Europe,” which again was music to the market's ears. Unsurprisingly, the euro has rallied on Draghi’s positive comments; EUR/USD has bounced by almost two cents.

These comments build on the relief story that was delivered yesterday by ECB policymaker Nowotny. Nowotny indicated that the European Stability Mechanism could be granted a banking license, which would in turn increase its lending capacity. The eurozone’s inadequate ‘firewall’ has long been a major gripe of investors and the fact that there are members within the ECB looking to address this was greeted with open arms. It goes without saying that Nowotny’s comments are a long, long way from becoming policy and he will certainly meet some stiff opposition within the central bank.

This week’s jawboning really ramps up the pressure on the ECB to deliver some emergency policy response of note at its monthly meeting next Thursday. If it fails to deliver a convincing plan on how to bring down Spanish and Italian bond yields which are threatening to force both countries into bailout territory, the euro is likely to come under some fresh and considerable selling pressure. Restarting the ECB’s bond-buying programme, which has been on hold for several months, would be welcomed enthusiastically, as would quantitative easing. Some action will surely come next week, as the ECB is forced to fill the policy vacuum left by the EU’s dithering politicians.

Richard Driver
Analyst – Caxton FX
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EU leaders sidestep eurozone growth issue

So the euro has made some monster gains this month, first as a result of hopes and speculation of major action on some key eurozone debt issues, which were then built upon when EU leaders finally delivered the goods. Bailout fund enlargement, recapitalisation, Greek haircuts – some major decisions were made (though a whole world of detail remains yet to be negotiated). But what about another key issue that was cited as a priority in the build up to the EU Summit- eurozone growth.

Weak growth is plaguing the eurozone periphery; the austerity programmes in countries like Greece, Spain, and the ones that will soon be implemented in Italy are strangling any sort of economic expansion. Perhaps even more alarmingly, growth in the core nations of France and Germany has also slowed down considerably, leaving a dip back into a full eurozone recession a strong possibility.

Without plans for economic growth, the peripheral states will be unable to meet their austerity targets, and again they will come under heightened pressure in the bond markets. One way EU officials can help eurozone growth is through cutting interest rates. The ECB has been looking to hike throughout 2011, the eurozone base rate has risen from 1.00% to 1.50% to curb rising inflation. This has triggered gains in the strength of the single currency which has hurt the periphery further.

Incoming ECB President Mario Draghi will be chairing his first meeting next week, with Trichet having finished his tenure this month. It is not beyond the realms of possibility that he will respond to the downturn in regional growth by cutting interest rates and relieving some pressure. With inflation up at 3.0%, the ECB may be wary, and recent data actually showed that money supply growth accelerated in September. The markets are anticipating a 0.25% rate cut by the end of the year. Perhaps the periphery will have to wait until December for some respite.

The growth issue will come up again and again in coming months and years. It was clearly sidestepped at Wednesday’s EU summit, but the markets will force EU leaders to revisit it.

Richard Driver
Analyst – Caxton FX

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Inflation response: ECB vs MPC

With the eurozone’s headline inflation running at 2.4% (y/y), the surprisingly hawkish comments from ECB President Trichet shocked the market by indicating that the ECB is likely to raise interest rates by 0.25% (from 1%) in April. UK inflation sits at 4.0% and will in all likelihood have increased beyond this point when the latest figure is released next week. However, in contrast to the ECB the BoE remains reluctant to raise interest rates, with the market pricing in a move by May at the very earliest. Both central banks have an inflation target of 2.0%, so what can explain this divergent approach?

Well, as the 0.6% GDP contraction in the final quarter of 2010 showed, the UK’s recovery is by no means guaranteed, with the dangers of stagflation and a double dip recession never far from focus. UK unemployment remains very high (nearly 8%) and the effects of the UK government’s austerity measures are yet to be truly felt by already tight household budgets. An interest rate hike is only likely to exacerbate these issues and the dovish majority within the MPC take the view that temporary factors are responsible for high UK inflation (such as VAT, oil prices and past sterling weakness). These factors are expected to fade over the longer to leave inflation on target. In truth, the UK’s recovery is on somewhat shakier ground than the eurozone’s (when taken as a whole) but the BoE risks losing credibility on tackling inflation.

The ECB’s more hawkish response is due to a stricter commitment to price stability, rather than the MPC’s approach of balancing this remit with stimulating economic growth. This can perhaps be put down to a more optimistic outlook from the ECB on eurozone and indeed global economic growth.

However, whether or not the ECB’s impending rate rise is prudent, remains to be seen. The move is not without its serious risks to ongoing eurozone periphery debt levels and bond yields - unemployment rates and budget deficits in states like Greece and Portugal vastly overshadow the UK’s. Much faith is being placed on German economic growth to drag the periphery out of recession but the rate rise could yet prove to be self-harming for the eurozone.

And finally, what implications does the ECB’s April rate rise have on the likelihood of a similarly early move from the BoE? That the ECB is convinced of the need to tighten monetary policy may persuade some of the more dovish MPC members to join Sentance’s growing hawkish faction (currently out-numbered by 6:3). However, the eurozone is the UK’s biggest export partner, and if an ECB rate hike slows demand for UK products then this could take much of the heat out of the British economy, which in itself could ease inflationary pressures

Fundamentally, the deciding factor for the MPC is likely to be the UK’s GDP performance in the first quarter of 2011 and if it does bounce back strongly, the MPC will find it difficult to resist tightening policy.

Richard Driver

Analyst – Caxton FX


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