ECB Preview: An instrument For SMEs

We expect the Governing Council to discuss rate cuts as the recession has deepened across the euro area. We estimate the likelihood of a rate cut is 25%.

The main reason for the ECB to hold rates unchanged is that it continues to expect the economy to improve in the medium term.

In addition, the monetary transmission mechanism remains broken so that the real economy would not benefit fully from a rate cut.

Instead of a rate cut, we expect Mario Draghi to present a new non-standard measure targeted at improving credit conditions for small- and medium-sized companies.

If Draghi comes up with alternative measures such as a lending programme to SMEs, we believe it should lead to an increase in longer term core bond yields and some EUR strengthening.

Data Turns Softer -- Time For Action?
We expect the Governing Council to discuss rate cuts once again, as economic indicators have continued to soften and signal that the recession deepened across the euro area in March. The weak economic indicators partly reflect the continued political uncertainty in the euro area. Cold weather and the Chinese New Year may also explain part of the economic weakening but probably just a small part. However, looking at the details there really is no reason for the global recovery having bypassed the euro area until now.

The fiercest opponent of a rate cut until now have probably been Germany, the Netherlands and Finland. Economic indicators suggest that while the economic situation in Finland has improved since the last Governing Council meeting, the recession in the Netherlands seems to have deepened and German manufacturing PMI has moved back into recessionary territory. The resistance to a rate cut might thus be less fierce this time.

Nevertheless, we do not expect the ECB to deliver a rate cut. The main reason is that the ECB seems to trust that the medium-term outlook has not deteriorated much since the last meeting. We assume the Governing Council maintains the view that as long as the medium-term outlook is acceptable the ECB should not cut rates further. The message that the economic outlook remains intact was given by Executive Board member Yves Mersch as recently as 27 March, when he said he saw no evidence that the outlook is deteriorating and that ‘We still expect a slow but gradual recovery of activity [beginning with] the second half of the year’ but the question is how patient the ECB can be. It would probably be a mistake to ‘wait and see’ for much longer when early signs of a recovery are failing to materialise.

All in all we put the likelihood of a rate cut this month at 25%. If the Governing Council decides to cut rates, a refi rate cut seems most likely, as this would be most beneficial for peripheral countries and Draghi has described a deposit cut to negative territory as ‘uncharted waters’ and said the unintended consequences of a measure like this could be serious.

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