ECB Meeting: Trichet almost Light-Hearted

• Trichet seemed slightly more positive today than at previous press conferences. He did not introduce any new non-standard measures and did not express concern about the latest market developments.
• In a gesture of confidence, he said that market observers have been too pessimistic on the capacity of EU authorities to take necessary decisions.
• Trichet noted that the need for intervention in the government bond market has been diminishing and that it looks like a trend. Sterilisation will continue.
• We expect that the ECB will cautiously stay on the exit path and we still anticipate a first hike in H2 11.
• If there is a significant negative market reaction when the stress tests are revealed on 23 July, the ECB will stand ready with the appropriate instruments.
• The market reacted with EUR/USD trading higher, a steepening of the EONIA curve and increasing European stock prices.

The ECB did not signal concern about increasing rates

This month we titled our ECB preview "Don't expect too much". Indeed, Trichet did not introduce any new non-standard measures nor did he express concern about the latest market developments. Instead, he explained in detail in the Q&A how much excess liquidity had been reduced after the 12-month LTRO and that the increase in market rates was a natural consequence. Later, he said that it would be a mistake to interpret these market moves as a monetary policy signal. He added that it is a result of the banks own decision to reduce liquidity (as the ECB is still offering full allotment at its auctions) and that it is not surprising this is reflected in the market.

Positive on growth

Overall, Trichet seemed slightly more positive than at previous press conferences. On economic developments, he said that a strengthening of economic developments took place during the spring and that Q2 is likely to have been much better than Q1. Keep in mind though that growth was just 0.2% q/q in Q1, so this is not surprising. Looking forward, he reiterated that growth will be moderate and at an uneven pace. On monetary developments he sees a possible turning point in loans to non-financial co-operations (positive in May), but also said that it was too early to tell.

In a gesture of confidence that policy makers have been doing the right thing, Trichet said that market observers have been too pessimistic on the capacity of EU authorities to take necessary decisions.

Diminishing government bond purchases

With regard to the Government bond purchases, Trichet said that the need for intervention has been progressively diminishing and that it looks like a trend. This trend may well continue, but keep in mind that the ECB government bond purchase so far has been modest. If confidence in southern Europe deteriorates, we would not be surprised to see that the ECB would have to purchase bonds at a faster pace than what we have seen until now. Trichet also said that the failure to fully sterilise government bond purchases last week was not surprising as it coincided with the EUR442bn loan payback and that the sterilisation will continue.

The ECB stands ready on 23 July

Trichet welcomed the bank stress test and the publication of results for individual banks, but despite many questions on the issue, he revealed little new information. He did not address whether funds from the stabilisation fund could be used for rescuing banks, but did say that flexibility is needed in respect of the stabilisation fund. We believe that the bank stress tests will reveal that most banks are fine, but that this is partly a result of the stress test design. If there is a significant negative market reaction when the stress tests are revealed on 23 July, we expect that the ECB will stand ready with the appropriate instruments, but we do not believe that this scenario will materialise.

First hike in 2011

The global economic outlook has weakened somewhat in recent weeks. At the same time, we have received some comforting news that Greece and Spanish government bond auctions have been relatively successful, so risks of sovereign defaults within Europe seem to have diminished. We expect that the ECB will stay on the exit path. It is likely that full allotment will continue for the rest of 2010, but we do not currently see the reintroduction of six and/or 12-month LTROs. Overall, we stick to our expectations of a first rate hike in H2 11.

Market reaction

The EONIA curve steepened further, which was especially seen around the six-nine month maturities, which are up roughly 5bp. Meanwhile, three-month EONIA is up around 1bp. Peripherals are higher in Europe - especially Spanish bonds, which are performing well. Spanish two-year yields are down almost 10bp compared with prior to the press conference. EUR/USD and European stock markets are higher than before.