Will ECB Wait Until December To Cut Rates?

We expect the ECB to wait until December to cut rates and use Thursday’s meeting to intensify dovish commentary about the currency’s role in supressing inflationary pressures.

December is more suitable for a rate cut when the inflation data for October and November are more complete.

Inflation may be excessively low, but the stability of Eurozone market and macro metrics (periphery spreads, business surveys and credit outlooks), mean the ECB can afford to hold fire until December, when it releases its quarterly forecasts.

Last week, EUR/USD posted its biggest weekly decline since July 2012 amid fears that the European Central Bank may cut rates at this Thursday’s Council meeting. These fears emerged after last week’s release of the Eurozone October flash CPI showing 0.7% y/y, the lowest level since November 2009. Markets were expecting 1.1%. A minority of banks have changed their forecast, expecting a rate cut from the ECB.

One way the ECB may cut rates without dragging the deposit rate to below zero is to reduce the refinancing rate (benchmark rate) by 25 bps from the current 0.50%. Another way is to reduce the marginal lending facility rate from 1.0% to 0.50% while leaving the deposit rate (lowest rate) at 0%. A rate cut is not a done-deal, but the ECB could opt for rate reduction to supress any renewed strengthening in the currency. Before we explore the likely impact on the euro, let’s assess the differences between the conditions prevailing today and those in early February when the single currency hit 1 ½ year highs before tumbling 7.0%.

1. Eurozone inflation is at 4-year lows at 0.7%, well below the ECB’s preferred 2.0% level and substantially above the 1.8% prevailing in February. Since the ECB was concerned in February about the impact of a high euro on price stability, it should certainly be concerned now.

2. Excess liquidity at the ECB stands at a 2-year low of €158,000 vs. €487,000 in early February. Sub-par inflation and low liquidity should raise the ire of even the most hawkish of Eurozone central bankers. Recall that liquidity began to drop sharply late in February as banks began repaying proceeds from the ECB’s Long Term Refinancing Operations.

3. ECB may consider offering a 3rd LTRO to shore up liquidity as a back-up measure to stabilizing inflation in the event it perceives a rate cut would not be sufficient. Yet, the central bank is careful not to use up too much of its policy armoury. Inflation may be excessively low, but stability metrics in capital markets as well as macroeconomic progress in the core nations and some periphery nations are more robust today than in February.

Euro Impact
The euro’s reaction this Thursday should depend on: i) whether there is a rate cut in either the marginal lending or refinancing rate; ii) whether the deposit rate will be cut to below zero; iii) the extent to which the ECB will refer to currency strength in the pre-conference statement and during the conference.

A drop in the deposit rate—the least likely of the three — would sustain the most damage on the euro, but a rate cut in the refi or lending rates would also weigh on the currency as it the base forecast includes no rate cut at this week’s meeting.

A decision to keep rates unchanged would trigger a knee-jerk rally in the currency until president Draghi kicks off the press conference with particularly dovish commentary about the currency’s role in supressing inflationary pressures. The July trendline currently shows support at 1.3500, which will have to be broken on Friday for the trendline to be considered to have been breached. A decline below 1.3490 is expected to see limited downside near the 100-day moving average of 1.3340, which draws a near confluence with the 200-week moving average at 1.3320. Recoveries towards the 1.3500 level are likely to be short-lived until the December council meeting is out of the way.
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