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Thursday, October 6, 2011

ECB interest rate decision

Updated with the current ECB decision and Mr. Trichet's statement

With the approaching of the ECB meeting on Thursday it seems the markets are getting more nervous and volatile. EUR lost more than a percent against USD on Monday and regained that percent back in Tuesday. US equities followed suit although their movements were far bigger and the changes were about 3% in both directions. The "fear index" VIX moved about 10% up and down for the first two days of the week.

The US equity markets finished strongly upward on Tuesday as FED's chairman Mr. Bernanke assured the markets "he’ll push forward with further expansion of monetary stimulus if needed ". After the strong selling during the last weeks and rebounding from the new low for the last two months made on Tuesday, the market seems hungry for good news. Mr. Bernanke's speech fitted well into such market expectations.

On the other side of the ocean Europe is still struggling with its sovereign debt problems. The Moody's Investor Service cut Italy's credit rating to A2 from Aa2 which at first made European equity markets to stay behind the increase of the US market from Tuesday. Later during the day the EU stocks advanced. Such an increase amidst credit rating downgrade (although possibly expected), an unexpected drop in EMU Retail Sales (YoY) of -1% and a decrease in Purchasing Manager Index Services in EMU could speaks of a strongly oversold sentiment. The same sentiment seems to be present in the US equity markets also.

So if everyone is focused on the ECB decision on the interest rate on Thursday, let's elaborate a bit on the possible outcomes.

Chart 1. Inflation in euro area, annual, non-seasonally adjusted; Source: ECB

The market consensus is that the ECB would leave its rate untouched at 1.5%. Any deviation from that consensus could sparkle market movements in both directions. Even if the ECB does not change the rate, the language it would use in the press release could signal the bank's further intentions.

In general ECB is strongly concerned with price stability. The last data on inflation in EMU showed an increase to 3% on annual basis after previously decreased a bit. Thus the market consensus that ECB would leave the rate unchanged seems reasonable enough as any further increase in the money supply by lowering the rate has the potential to increase the inflation pressure.

On the other hand data from October 5, 2011 show the growth in euro area slowed significantly to 1.6% (YoY) from the previous 2.5%. The combination of a high inflation and a slow growth does not seem to be in favor of any further increase in the ECB interest rate in the short-term. Such a combination however, does neither support a strong decrease in the rate which the currency markets seem to be hoping for as that would boost inflation. So basically that puts the two extreme options – an increase in the rate and a strong decrease out of the table for now.

We are then left with those two – rates unchanged as is the market consensus and a small decrease which would be a surprise given the consensus.

If the interest rate is left unchanged that would not have any significant direct effect on the markets as this outcome seems already priced in. The markets could continue to be moved mostly by oversold moods and short rallies. Not lifting the rate given the present weakness of the euro combined with the sovereign debt problems in EU however, could signal the ECB is not so strongly on the euro defensive position at the moment. That could increase the short-term confidence in the EU common currency or at least not hurt it further. All that however does not seem so strong to present a long-lasting and deeper change in the market sentiment if we account for the sovereign debt problems as well.

The second option which seems possible given the slowing growth, is a decrease of .25 basis points to 1.25%. Such an decrease would not hurt so much the interest rates differential between USD and EUR as to strongly send the Euro further down. Such a strongly weaker euro scenario does not seem a desirable outcome for the EU officials either.

A small decrease in the rate would be a surprise given the consensus and could give equity markets confidence the ECB is concerned with growth in EU at least as much as it is with price stability. That could more possibly result in EU markets increase than in US but in general both markets follow suit. The current negative sentiment resulted in a bit oversold market condition on both sides of the ocean and lead to a series of bullish divergences in EU stock markets on a short-term scale. In this light such a decision could lift up the world equity markets for a while as it would mark a possible shift in risk taking. In a longer perspective however, the commodities prices should be watched as they are able to present a big pressure on a macro level and limit growth while increasing inflation.

The ECB decided to leave its main refinancing rate unchanged at 1.5% so basically there were no surprises. Still the bank sees the situation as worsening concerning the EU growth prospects in the following months. ECB officials believe the inflation will continue to float above the 2% threshold but it will eventually calm down further on the line. Given the growth continues to be sluggish and inflation calms down, a coming decrease in the rate of at least .25 basis points could not be ruled out in the months till the end of the year.

You may also want to check the full text of Mr. Trichet's statement concerning the ECB decision on its rates.