ECB Enters Wait-and-See Mode

• ECB rate cuts over for now, as monetary stimulus takes time to work through the economy
• Signs of economic improvement continue but conditions remain weak
• Details covered bond plan and new ECB staff growth and inflation projections will command attention
• Trichet to leave all options open; comments on the strength of the euro closely watched

At their policy meeting last month, the ECB governing council announced both conventional and unconventional decisions. In line with expectations, the governing council decided to cut the main policy rate by a further 25 basis points to 1% and to extend the maturity of its refinancing operations to a maximum of 12 months. In addition, it decided to accept the EIB, as an eligible counterparty in the Eurosystem's monetary policy operations from 8 July onwards. This will enhance the EIB's role as a source of financing for businesses across the euro zone. Perhaps, the most important and surprising decision, however, was the announcement of an intention to purchase euro-denominated covered bonds issued in the euro area. The details of the purchases will be announced at this week's meeting, but Trichet signalled that the amount involved would be around €60B.

By purchasing covered bonds instead of following the Fed or Bank of England example and purchasing government bonds and/or corporate bonds, the ECB has chosen to continue to focus its support efforts on the banking sector. Covered bonds are bonds issued by credit institutions with a claim on both the issuer and a pool of high-quality collateral, which are typically mortgage loans and loans to the public sector. The recourse to the issuer and consequent lack of credit risk transfer distinguishes covered bonds from asset-backed securities, and makes them among the safest investments available. The decision by the ECB to purchase covered bonds should be seen as complementary to the extension of the maturity of the refinancing operations to 12 months. The longer refi operations should assist short-term funding conditions for banks while the purchasing of covered bonds should enhance longer-term funding conditions. So, these measures should help to improve financing conditions in the euro zone economy, via the banking sector. The announcement of the purchases has already succeeded in breathing new life into the covered bond market, as several banks have announced the issuance of covered bonds since last month's ECB meeting.

Following last month's important decisions, we expect the ECB governing council to adapt a waitand- see stance on further policy initiatives. The rate cuts and unconventional measures already undertaken will take time to work through into the 'real' economy. It usually takes 6 to 15 months before the full impact of the rate cuts is felt. In addition, there have been hopeful signs that the worst of the recession is over. Indeed, PMI surveys have improved clearly in the past three months. Against this backdrop, it will be very interesting to see new ECB staff projections for growth and inflation, as these will provide further insight into ECB thinking on how far we are from a sustainable recovery.

There is little question that particularly weak conditions late last year and in the very early part of 2009 make inevitable a downgrading of both growth and inflation forecasts for 2009. Indications from both the EU Commission spring forecasts and the recent ECB Survey of Professional Forecasters point towards fairly significant adjustments to activity forecasts in particular. More interesting, however, will be growth and inflation projections for 2010, as there is some discrepancy between the EU Commission Spring forecasts and those from the Survey of Professional Forecasters.

Overall, we expect the ECB president Trichet will want to keep all options open with regard to interest rates as well as quantitative easing reflecting a still uncertain economic outlook and divergent views within the ECB governing council. At their previous policy meeting in May, Trichet described the 1% interest rate level as 'appropriate', but indicated that further rate cuts couldn't be completely ruled out by saying that 'we have not decided that the new level of our policy rates was the lowest level we could never cross'.

Over the past month, short-term yields have remained low, but longer-term yields have been moving higher on a global level. This has been mainly due to a rebound in inflation expectations, as deflation fears at the beginning of the year have abated due to recent improvements in activity indicators and a rise in commodity prices.

This sharp rise in longer-term yields has increased the pressure on the Federal Reserve to augment their purchases of US Treasuries. The rise in yields indeed pushes up mortgage rates and thereby threatens any stabilisation in the US housing market, which is key to an economic recovery. This pressure on the Fed comes at a time the dollar is already very weak. Therefore, a further rise of the euro on a trade weighted basis may become an increasingly important issue for the euro zone economy and may put also the ECB under increasing pressure to become more aggressive in their monetary policy. As such, any comments from Mr. Trichet on the strength of the euro could also be significant from a monetary policy point of view.

From a technical point of view, German 10-year yields have approached very interesting levels, as they are currently testing the neckline of a longer-term double top formation at 3.68%. A sustained break higher would deteriorate the longer-term technical outlook for bonds and signal that the era low longerterm yields is over. In this context, any long bond position needs tight stop-loss protection.

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.