- It is, in our view, 100 percent certain that the ECB will keep interest rates unchanged at this month’s Governing Council meeting (keep in mind though that events with a zero percent possibility can happen, although not very often).
- Recent economic data has been mixed, but not so weak that a rate cut would be justified. In addition, the ECB remains in wait-and-see mode as it assesses the impact of the two 3Y lending operations. Although we expect the euro area to exit the recession soon, we expect the ECB to abstain from rate hikes until early 2014.
- The ECB has twice reacted to sharply increasing oil prices by hiking rates. We do not believe that the ECB will make this mistake again. In the current environment higher oil prices are unlikely to drive up wages. Instead, higher oil prices are likely to reduce consumers’ purchasing power and thus drive down demand. In case of a continued rise in oil prices the euro area economy will probably need lower rates rather than higher ones.
- It is too early for the ECB to engage in an exit strategy for its non-standard measures.The market will nevertheless look for indications of whether the governing council is considering terminating some of its non-standard measures – not least the Securities Market Programme, which has been asleep for some time.
- Market reaction is set to be moderate if the ECB keeps rates unchanged and doesn’t signal any steps towards an exit on non-standard measures. If Mario Draghi signals more explicitly that higher oil prices will not cause the ECB to hike rates prematurely this may help to fuel a more positive market sentiment. ECB To Keep Interest Rates Unchanged
We expect ECB to keep rates unchanged for a prolonged period until early 2014. The reasons for the ECB not to cut rates further are:
1) Market sentiment has improved a lot since December – not least due to the ECB’s LTROs;
2) Economic data is improving and in particular US data shows signs of a recovery. Our soft and hard data models indicate slightly negative growth in Q1 and we forecast growth turning positive in Q2;
3) Higher oil prices caused partly by the sanctions on Iran have put some upward pressure on inflation, which only fell to 2.6% in March and is set to remain above the ECB’s 2% target throughout 2012 and probably in early 2013 as well, according to our projections. In euro terms, the Brent oil price is now at its highest level ever;
4) A Taylor rule based on core inflation signals that ECB should be on hold, although our speed limit approach signals a 0.5% rate cut, but as it is unable to take the 3Y LTROs into account, this is somewhat misleading;
5) EUR/USD has strengthened since the beginning of the year, but the level is by no means alarming.
The ECB has now twice reacted to sharply increasing oil prices by hiking rates. We do not believe that the ECB will make that mistake again. In the current environment of low capacity utilisation and high unemployment, higher oil prices should not drive up wages and other prices. Indeed, inflation expectations remain well-anchored. Instead, higher oil prices will reduce consumers' purchasing power and thus drive down demand.
In case of a continued rise in oil prices the euro area economy will therefore need lower rates rather than higher. We doubt that Mario Draghi would go as far as cutting rates if oil prices increase further, but maybe it is something he should consider, in our view.
The Easing Cycle Has Come To An End
We think LTRO II was the end of the easing cycle, but it is probably too early for the ECB to engage in an exit strategy for its non-standard measures or communicate on the details of a future exit strategy. The Governing Council may very well discuss a termination of some of its non-standard measures like the Securities Market Programme. We think that the ECB will keep the programme asleep, but readily available.
The same is the case for the second round of the covered bond programme, where purchases are currently running behind target. We would very much like to know in some detail what could trigger the ECB to absorb some of the excess liquidity provided through the 3Y LTROs. If Draghi offers some insights on this it the market might see this as an indication that the ECB is moving towards a tightening bias.
Debt Crisis – Part Two
A second round of the debt crisis should not be ruled out. Government bond spreads have started to rise again. The Spanish housing market and Cajas are bound to provide negative news. Portugal will probably need another rescue package. This could cause some turmoil, but for now we do not expect this to result in more easing from the ECB. A Portuguese default cannot be fully ruled out. If we approach such a scenario the ECB may have to do more to calm the markets.
Market Reaction
The market is not pricing in any rate changes and if the press conference offers little new information as we suspect a rather muted reaction.
If Draghi signals more explicitly that higher oil prices will not cause the ECB to hike rates prematurely, the markets may react with increasing stock prices, lower rates and higher EUR/USD (due to more positive risk sentiment).
Draghi may continue to celebrate the success of the 3Y LTROs, but recent data has been mixed, so for now he will probably downplay his satisfaction with the ECB strategy somewhat.