ECB Preview: Good cop, bad cop
I expect the European Central Bank (ECB) to play the good cop, bad cop routine on Europe. The governments and voters of Italy and Spain should not be given too much hope that the ECB will backstop everything, and thus we will probably hear another round of explanations on how things are improving: banks repaying long-term refinancing operation (LTRO) loans; bond spreads and CDS prices being low; the international economy slowly picking up, and any remaining problems are to be met with structural changes and slow deleveraging. That is the ‘bad cop’, or the whip: no rate cuts or unconventional easing for you.
A carrot is also needed, so the ‘good cop’ will promise to monitor the situation closely, and maybe even hint at the possibility of a rate cut if things deteriorate, as the latest moderate inflation statistics and terrible macro numbers in peripheral Europe would allow that. Maybe we will even get some sort of rate guidance that the ECB will be withholding from raising policy rates for the foreseeable future. The effect on markets will be subdued, with perhaps a slight decline in market interest rates and EURUSD, especially ahead of the Italian elections. A decision to not cut the rates without some soft talk would be positive for the EURUSD. The key to trading this event is looking for those dovish words. If there are not any, we might see another attempt higher.
After an announcement of decisions at 12:45 GMT, Mario Draghi, the ECB president, will hold a press conference, beginning at 13:30 GMT with a reading of a pre-written statement, followed by a Q&A session with the press. You can follow the conference live on ECB’s video feed. The previous statements and Q&A-notes: 10-Jan-2013 and 6-Dec-2012. It is always a good idea to review them, then look at the changes. You might want to check my earlier comments: 10-Jan before and after, 6-Dec before and after.
I will be commenting the event live, so follow me on Trading Floor to catch my squawks during the day.
The notable changes since the last governing council meeting are:
Higher interest rates - Lower-than expected inflation numbers
The rise in short-term euro interest rates happened because of the market’s perception that the easing cycle is now over. The consensus around November was that a rate cut in the beginning of 2013 was in the cards. Draghi crushed these views in his January press conference and accelerated the rise in market rates. The latest inflation numbers from the Eurozone came in slightly below expectations at 2 percent. One of the reasons why the ECB did not cut rates was that the market rates were already near zero. Cutting the central bank rates would obviously not have had much of an impact at that time. Now it is different – a rate cut would actually be an effective policy measure. The polls see a very limited chance of a rate cut, with only a 2-10 percent chance for a cut now.
Stabilising but fragmented Eurozone economy - Record-high unemployment
While the purchasing manager indices show a return to growth for the Eurozone as a whole, almost all the growth comes from Germany, which has been riding on cheap money and export-led growth. Even France has lately shown terrible numbers. The old acronym PIIGS (Portugal, Ireland, Italy, Greece, Spain) will soon have to be updated to include some new members. Unemployment is also at record levels, and also here the Europe is very much divided.
Declining lending - LTRO repayments
The latest figures confirmed contractionary lending practices especially in the periphery. While the LTRO repayments obviously drained some liquidity from the banking system, there is still plenty left. The decreasing lending is caused by half of Europe deleveraging and suffering from a demand shock, while lenders are worried about credit risk. No amount of liquidity will solve the true problem.
The ECB is not targeting exchange rates, at least officially – but Draghi did say the obvious one that it is a factor that the central bank is following, as it does have an impact on price stability and growth prospects. As the euro gets stronger because of the ECB's outright monetary transactions programme (OMT) backstop and other central banks being much more expansionary, European exports will become less competitive internationally.French premier Francois Hollande already suggested managing the exchange rates, and Germany countered the idea. I have seen estimates of 1.40 and 1.50 being pain thresholds. Probably at 1.40 we would see dovish talk from the ECB, and perhaps from member state’s leaders. If 1.40 is penetrated, concrete measures would begin – intervention being the most probable weapon of choice.
The ECB does not interfere with the political process, at least officially. But after ousting Italian premier Silvio Berlusconi, and forcing austerity and denying debt restructurings and bank defaults in other peripheral countries, and being part of the Troika that oversees all the bailout programs, only a simpleton would state that the ECB is not a major player in Europe, second perhaps only to Germany.
The Italian elections are close (24-25-Feb) and the populists are catching up in the polls. The German elections are only six months ahead and the highly political and awkward EU budget and the bailout of Cyprus are still on the agenda. Spain's prime minister Mariano Rajoy has been dealt a major blow domestically, and thus in the EU circuits he cannot be trusted anymore. There are too many possible trouble spots on the map. The ECB does not want to stir the pot too much right now – especially as Draghi’s part in the latest Italian banking scandal could easily make any lecture attempts backfire.