ECB Cuts Again and Hints It May Not Be Finished

• ECB cuts rates to historic low of 1% and says it is not necessarily the lower limit
• We still think 1% will prove to be the low point but renewed economic weakness could prompt a further cut later in 2009
• ECB also announces further non-standard measures in the form of support to the covered bond market and increased lending capacity for the European Investment Bank
• These measures are small in scale but suggest the ECB is willing to take further radical action if necessary.

ECB rates approach bottom at 1%, what now?

Today's decision by the European Central Bank to cut its key refinancing rate by 25 basis points to a new alltime low of 1.00% was so well signalled that it had little impact on financial markets. However, there was considerable uncertainty about what signals the ECB would offer about the future course of interest rates and whether they would announce further 'nonstandard' measures to bolster lending and activity in the Eurozone.

Mr. Trichet went a little further than expected in announcing an intention to purchase covered bonds and to increase the lending capacity of the European Investment Bank. So, there is clearly a willingness and a capacity to step up support to the financial system. In addition, Mr. Trichet hinted that a further rate cut can't be ruled out entirely even if we think it still looks unlikely.

By saying that the current level of interest rates is appropriate, Mr. Trichet signalled there is little prospect of a further change in interest rates in the next few months. However, a more important development was that Mr. Trichet repeatedly emphasised that 'this is not necessarily the lowest limit for interest rates'. This seems to reflect a strong but possibly minority view on the Governing Council that further rate cuts may be required to support a fragile Eurozone economy. Technically, the possibility of further cuts may make some financial institutions more reluctant to take advantage of the new twelve month refinancing maturity also announced today as they may be reluctant to commit to twelve month funding if they feel rates could drop further. On the other hand, the ECB may feel markets will draw comfort from the possibility that the downtrend in rates hasn't ended. It may be better for traders to continue to travel hopefully than to arrive.

The main reason for Mr. Trichet to avoid definitive statements is that poorer economic circumstances might force the ECB to contemplate further rate cuts. Today's cut in the key refinancing rate brings the main ECB policy rate to a historic low. However, the scale of the downturn in global economic activity is unprecedented in recent times. Moreover, there is an emerging consensus that the Eurozone economy will shrink by more than the US and UK both this year and next. As a result, many feel the ECB response has been too timid. There is little question that the combination of major stresses in the financial system, a severe global downturn and a nonnegligible risk of deflation warrant an aggressive and sustained policy response. Diagram 1 shows that while the nominal ECB rate may be at historic lows, falling inflation means the 'real' interest rate is not particularly low at present and is well above levels seen for most of the period between 2003 and 2006. If inflation were to fall further than expected, the 'real' rate could rise dramatically in coming months.

For this reason and, critically, because of constraints on the availability of credit, it may take some significant time before there is a stabilisation in financial conditions sufficient to prompt a recovery in borrowing and a transition to 'normal' levels of economic activity. By keeping open the option of a further cut in rates, the ECB is correctly recognising the persistence of significant downward risks in what are unprecedented circumstances. Although we think a further rate cut remains unlikely, the prospect of very poor growth data for the first quarter accompanied by negative inflation through the summer months mean lower rates could become a real possibility if clear signs of a turnaround do not emerge by during the third quarter.

The main reason we still expect 1% to mark the lower limit for ECB rates is that recently there has been evidence of a tentative stabilisation in both 'real' economy and financial sector developments worldwide. In terms of activity, there have been a number of encouraging developments of late in the shape of a modest improvement in a range of sentiment surveys.

Today's unexpected rise in German manufacturing orders also hints that the recent period of freefall in the global economy may be behind us. If there are signs that the very worst may be over, in terms of the pace of decline in activity in the Eurozone and elsewhere, this doesn't imply the crisis is near to an end.

The prospective trend in Euro area GDP growth in 2009 and 2010 as illustrated in Diagram 2 still points towards a protracted period of extremely weak economic conditions. It seems most unlikely that activity in the Eurozone will rebound sharply in the next year or two. As senior US Federal Reserve official Janet Yellen recently observed in relation to the US economy, an eventual upturn could appear 'frustratingly tepid'. This implies the ECB needs to keep its policy options open. Mr. Trichet has done this today by holding out the possibility of further rate cuts as well as announcing two other significant initiatives today.

Today's announcement by the ECB that it will start buying covered bonds as well as the decision to allow the European Investment Bank access ECB refinancing represent significant if small first steps towards a broader array of support for the financial system and Euro area businesses.

Covered bonds are one of the oldest and largest elements of the European bond market. At the end of 2007, this market amounted to over €2 trillion. Covered bonds are dual-recourse bonds, with a claim on both the issuer and a cover pool of typically mortgage loans and public sector debt. Germany has historically been the dominant country in this market with significant activity levels also in France and Spain among Eurozone countries (Irish covered bonds amount to roughly 3% of the market, about double this country's share in Euro area GDP). Activity in the covered bond market has suffered from the financial turmoil particularly since last September and Mr. Trichet rejected questions at today's press conference that implied this initiative will give an advantage to German financial institutions. It should be noted that the ECB's announcement of an intention to purchase €60 bio of covered bonds represents a very limited intervention in the context of the size of this market. It should also be emphasised that the nature of the covered bond market means the ECB continues to prioritise support through financial institutions. That said, it is likely that investors will regard this announcement as setting a precedent that could translate into a broader credit support in the future if circumstances warrant such a course of action.

The ECB's decision to allow the European Investment Bank become a counterparty in the Eurosystem's monetary policy operations holds out the possibility of the EIB playing a much more significant role in efforts to restore the European economy to some form of normality. The ECB estimates that this will allow it generate additional investment of around €40 billion this year. As EIB new lending amounted to €57 bio in 2008 this implies a substantially increased capacity. Again, the key aspect is that the ECB is opening another door.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.