ECB Preview

Central bankers are increasingly using ‘open-mouth’ operations to influence market participants and their expectations. We’ve seen it from the Fed, the Bank of England, and the RBA’s Glenn Stevens used a speech to talk down the Aussie just this week. Expect Draghi to use similar tactics.

Rate decision: July 4th at 06:45 ET / 11:45 GMT / 21:45 AEST

Press conference: July 4th at 07:30 ET / 12:30 GMT / 22:30 AEST

Markets expect the European Central Bank (ECB) to hold its refinance rate at 0.5% and its deposit rate at 0% at its July 4th monetary policy meeting. As is often the case in modern capital markets, focus will be on ECB President Mario Draghi’s post-meeting press conference where unscripted questions are asked – rather than on the rate decision itself or the accompanying statement – both of which rarely diverge from consensus.

At last month’s meeting, the ECB was vocal about its intentions to tighten its balance sheet despite low inflation and meagre GDP growth across the Eurozone. The ECB would love to continue providing ample and cheap liquidity – but the sharp balance sheet expansion is not so desired. As we have seen over the past 5 years, whenever central banks run into a dilemma whereby they face off against market expectations, they tend to solve them by appeasing the market instead of doing what is most efficient, productive and conducive to the bank’s remit.

In the past few weeks, Draghi has reiterated his view that looser monetary policy and better confidence is likely to support economic growth in Q2/Q3 of this year. Reading between the lines suggests that he will further reinforce this view on July 4th at 06:45 ET / 11:45 GMT / 21:45 AEST as weak economic conditions continue and peripheral European countries struggle most.

We expect Draghi to carefully pick his words (as all central bankers do these days) but outline a dovish stance that is supported by other ECB members. Expect to hear his staple comment “We stand ready to act again when needed” several times without actually specifying the ECB’s actual plans. Forward guidance is unlikely to be provided.

Central bankers are increasingly using ‘open-mouth’ operations to influence market participants and their expectations. We’ve seen it from the Fed, the Bank of England, and the RBA’s Glenn Stevens used a speech to talk down the Aussie just this week. Expect Draghi to use similar tactics.

Data backdrop

The Eurozone manufacturing PMI index is still in contraction territory (<50), but gradually recovering. In June, the Eurozone composite PMI rose to 48.9 from 47.7. While this kept the Eurozone in contractionary territory, it was nonetheless the highest reading since March 2012. The German composite rose to 50.9, thereby extending private sector expansion into a second month and reducing the risk of contagion from the periphery to the core. This data supports the ECB's expectation of a Q2/Q3 recovery, mild and slow as it may be.

In broad terms, the mixed bag of economic statistics in Europe indicates an overall lag from other G20 countries. It’s worth noting that Europe needs higher than average growth rates in order to sustain the austerity/debt reduction programmes being conducted in almost all European countries. The fact that country specific austerity programmes assumed GDP growth >2%-3% shows just how overly optimistic those assumptions were. Other challenges are also evident – European unemployment rose from 12% in April to 12.2% in May (close to a record high).

Eurozone inflation remains below the ECB’s 2% target at 1.6% while core inflation is stable at 1.2%, underscoring that inflationary pressures remain muted. The economic climate therefore leaves the ECB with scope to loosen monetary policy further. The question is which type of policy they are likely to use. Cutting the refinancing rate further from 0.5% will probably have a very marginal effect on economic conditions while the discount rate is already at zero. We think Fed/BoJ/BoE style asset purchases are the most likely path the ECB will choose – when ECB members feel the need to do so. For the time being, market stress and short-term funding rates are largely stable but if we see debt problems escalate in Spain or large financial institutions run into funding difficulties similar to Lehmann Brothers in 2008 – we are likely to see an ECB QE programme initiated in full force – regardless of German courts, public opinion, inflation fears and market volatility.

Negative deposit rates

According to previous comments by Draghi, the ECB stands ready to implement negative deposit rates - as a way to discourage cash hoarding and encourage investment presumably. The danger here is that the vast amounts of unallocated capital would be rapidly deployed into higher yielding asset and raise inflation. We think that the ECB will talk about implementing negative deposit rates (in order to verbally influence the market) without having the conviction to do so. EUR outflows would be huge if the ECB moved from talking about negative rates to taking action on this issue.

The German ‘Suddeutsche Zeitung’ newspaper recently reported that the ECB is considering outright Fed-style QE, as the central bank is concerned that the German Constitutional Court’s ruling (due in Septemer after the German election) could render the ECB’s backstops as irrelevant.

Structural problems

Sovereign default fears are boiling to the surface in Europe once again. With the Portuguese government on the brink of collapse, questions hanging over Greece’s next tranche of bailout cash, continuing concerns about Cyprus and the two elephants in the room are still here: Italy and Spain.

Portugal

After two high-profile government resignations, the prospect of an election in Portugal is on the cards, and this may threaten Portugal’s bailout deal. Although European Commission president José Manuel Barroso expects a solution in the short term, the market is not so convinced: Portugal’s 10-year government debt yields are once again above 8%. The crisis could pose a test for the ECB’s bond buying programme, and the question is what options the ECB has, given questions about whether the OMT can be implemented.

Greece

Unnamed European officials were quoted by Reuters this week as expressing “a general dissatisfaction with progress in Greece when it comes to reforming its public sector, such as tax and custom collection or health care services.” There were also reports that the Troika (the ECB, IMF and European Commission) have given Greece until the end of this week to deliver a reform agenda, or face the prospect that the next €8.1bn bailout tranche may be withheld.

If indeed Greece cannot deliver on the reform agenda, what would the ECB do to contain a potential crisis? Speaking to German newspapers, Merkel has rejected the possibility of new write-downs on Greek debt, while giving a confusing message on whether or not the next bailout tranche may be delayed. Market participants will view this impasse as a reason to be uncertain and thus creates the possibility of further turmoil in Europe because its largest member (Germany) cannot fixate what/how/when it will deal with the European sovereign debt crisis.

Cyprus

Cyprus recently restructured its debt (through an exchange of around €1bn of existing government bonds), which all three major ratings agencies deemed as a distressed exchange, and moved Cyprus’s credit ratings to default. Subsequently, the ECB temporarily suspended the eligibility of Cypriot government debt as collateral in its Euro system money operations. The outlook for Cyprus is protracted, painful and subject to a lot of event risk. Cyprus is not so significant because of its size compared to other Euro member states but as a precedent, Cyprus is important: http://georgui.blogspot.com/2014/02/eu-finance-ministers-cooking-up-storm.html

Spain & Italy

The heavyweights out of all the PIIGS – with over a trillion EUR in funding required to prevent these countries from defaulting over the next 3 years, Spain and Italy are simply too big to fail if the ECB wants the Euro to exist past 2016. Undersubscribed bond auctions, weak GDP growth, rising unemployment, rising debt to GDP ratios, political disharmony, budget deficits, ageing populations and speculative capital outflows are just a few of the problems that could force the ECB to act. Bailouts of Spain/Italy would make the ECB’s rescues of Greece, Ireland, Portugal and Cyprus look like a bar tab. Without Spain or Italy the Euro cannot exist but funding their budget deficits and debt repayments whilst initiating savage austerity programmes amidst political wrangling is becoming increasingly difficult. If Spain or Italy require bailing out in similar fashion to Greece, the ECB will have to triple its existing balance sheet. This would likely require IMF involvement and would be catastrophic for the Euro.

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Commissioned by Think Forex

Written by George Tchetvertakov

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