ECB Will Cut Rates Again

We expect the ECB to continue its easing bias and deliver another 25bp rate cut on Thursday. Anything less would be a major surprise. The economic situation in the euro area has deteriorated notably and the risk is skewed towards a 50bp cut. Strong German orders yesterday have reduced the likelihood of a 50bp cut.

In addition to the rate cut, we expect the ECB to ease its non-standard measures by introducing 24-month LTROs with fixed-rate full-allotment auctions. Furthermore, it could ease collateral requirements.

We believe Mario Draghi is likely to urge politicians to take action and repeat the need for a stronger fiscal union. The ECB will probably be willing to step up its government bond purchases once the politicians have delivered convincing measures but we do not expect Draghi to give any promises in this regard.

Looking further ahead, we expect the ECB to deliver another 25bp rate cut in January, bringing the refinancing rate to new record lows. This is warranted in our view, as the headwinds from fiscal and credit tightening are likely to keep the euro area in recession well into 2012.

Market reaction is set to be moderate if the ECB delivers a 25bp rate cut. Longer LTROs would not be a major surprise either. A commitment to more bond purchasing would be a significant surprise and could give substantial market relief but, in our opinion, the ECB probably thinks it would be premature to give such a commitment on Thursday.

ECB expected to cut 25bp
We expect a 25bp cut at Thursday’s ECB meeting, which would bring the refinancing rate down to 1%. We see the risk relating to Thursday’s meeting as skewed towards a 50bp cut (we estimate a 15% chance), while unchanged rates would be a major surprise (we estimate a less than 5% chance).

The ECB is likely to retain an easing bias, reflected in a very downbeat tone with regard to the economic outlook and an emphasis on the limited risks of inflationary pressures in the medium term. For sure, the ECB is keeping an eye on the rising 5y5y market inflation expectations but as long as the inflation expectations in the Survey of Professional Forecasters are coming down, we do not think the ECB will be alarmed. A downward adjustment of the outlook in the ECB’s quarterly staff forecast for growth would also reflect this.

Furthermore, we expect the ECB to introduce 24-month LTROs with fixed-rate fullallotment auctions. There is a slim chance, in our view, that the ECB will go even further and offer even longer operations but we doubt this. Finally, the ECB might provide an easing of the collateral requirements on for instance covered bonds in an attempt to help the functioning of the financial system.

EU Summit and ECB response in focus
ECB officials appear to be opening the door for the ECB to play a bigger and more explicit role in stabilising the European bond markets, if the political moral hazard issues are diminished. An EU-27 or EU-17 agreement on fiscal co-ordination could be the token needed for the ECB to step up the bond purchase programme, or to announce more explicit support for the sovereign bond markets. In a recent testimony to the European Parliament, ECB governor Draghi said the following.

“We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility...Other elements might follow but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right.”

There have been a few hints from euro area leaders that the ECB could increase its crisis response if politicians can come up with a proposal that mitigates the moral hazard problem in the EMU. Hence, communication from the ECB in the weekend following the summit will be key.

Staff projections to be revised
The ECB quarterly staff growth projections are likely to be revised down significantly for 2012 reflecting the continued deterioration in the economic outlook since its September projections. We expect real GDP growth projections for 2012 to be cut from 1.3% to 0.5%, while the projection for 2011 could be left unchanged at 1.6%.

The ECB inflation projections could be revised slightly upwards, which would
reflect primarily that current inflation remains surprisingly sticky at 3%. We expect a 0.1pp increase in the growth projections for both 2011 and 2012 to 2.7% and 1.8%, respectively.

Market reaction
Market reaction is set to be moderate if the ECB delivers a 25bp rate cut. Longer LTROs would not be a major surprise either. A commitment to more bond purchasing would be a significant surprise and could give substantial market relief but we doubt that the ECB is ready to announce this yet.