The ECB Surprises Two Times

• ECB cuts rate by a smaller than expected 25 basis points...
• ...but hints that one more 25 basis cut is likely.
• ECB facing a range of problems in introducing 'non-standard' measures...
• ...but promises an announcement of extra action next month
• Today's decisions hint at serious differences of opinion within the ECB Governing Council.

Today's decision by the European Central Bank to cut its key interest rates by 25 basis points rather than the 50 basis points widely expected by financial markets has come as a significant surprise. So too was the absence of any announcement of additional 'non-standard' measures to support the financial system and the broader European economy.

Today's small rate cut comes against a backdrop of sharply falling inflation and rapidly rising unemployment in the Eurozone as well as this week's recommendation from the OECD that scope for rate cuts 'should be used fully by keeping or bringing policy rates near zero and committing to keeping them at that level for some time to come. The monetary authorities should also be ready to implement or expand their use of direct measures to support credit creation, enhance liquidity in markets and to limit deflationary pressures.' 1 Judged from this perspective, today's ECB decision was disappointing. As a result, Mr. Trichet's press conference was keenly awaited.

At the press conference, Trichet did hold out the prospect of one further 25 basis point cut in the refinancing rate as well as an announcement of some additional 'non-standard' measures to support the financial system in early May. However, today's ECB action and comments also hint at some important divisions of opinion within the Governing Council.

Mr. Trichet tried to reduce market disappointment in his responses to questions at the monthly ECB press conference today. He indicated that today's rating action did not mean the lowpoint for the key refinancing rate had been reached. He suggested that a further 'measured' cut like today's 'measured' action was possible. So, expectations of a further 25 basis point cut, probably as early as next month, are likely to become priced into market rates. Mr. Trichet also indicated that the ECB was likely to announce further 'non-standard' policy actions at its early May meeting. As a result, financial markets will continue to travel hopefully in the hope that next month's meeting will bring a further drop in the refinancing rate and substantive measures to improve the working of the financial system and breathe life into the Eurozone economy.

It might be argued in the ECB's favour that it wants to choreograph the introduction of further non-standard measures and that a further cut in the refinancing rate will form part of a package of measures to be announced after the ECB's next policy meeting on the 7th of May. While this is possible, other more plausible and slightly less encouraging reasons also suggest themselves. First of all, it would appear that, as was the case last month, today's decision was not unanimous. It could be the case that divisions within the ECB Governing Council are widening. One set of divisions could reflect differences in opinions in regard to the severity of the downturn as well as more substantive differences as to how aggressively the ECB's response should be given that its orientation is on medium term rather than short-term developments. In this context, it should be noted that the ECB has now cut its refinancing rate on six occasions within the past seven months. Mr. Trichet noted today that although inflation might slip further in the near term, the medium term outlook was still pointing towards inflation being in line with the ECB's target of a rise in consumer prices of less than but close to 2 per cent.

Another possibly important split may be in regard to the sort of 'non-standard' instruments it should use and the scale on which they should be deployed. Differences in the structure of financial sectors as well as the particular circumstances of these sectors across the sixteen countries making up the Eurozone would tend to amplify such concerns. It should also be appreciated that the ECB must be careful to assess what unintended consequences such measures might have across sixteen economies and financial systems rather than on a single market. These differences make it harder for the ECB to 'feel' its way in the current climate. Indeed, because we are in unprecedented circumstances, it is impossible to predict with any confidence how effective various types of unconventional measures are likely to be in practice, what 'dosage' of these intensified medicines might be required and what unintended consequences might arise. These considerations, together with the ECB's natural caution point towards today's hesitation.

Yet another cause of hesitancy might be uncertainty about the interaction between the refinancing rate, which is the ECB's key policy rate and its deposit rate which tends to set a floor for interbank interest rates. Usually, the refinancing rate tends to be the dominant influence on interbank rates in the Eurozone but in recent months the increase in the amount of liquidity the ECB injects into the system has seen short term interbank rates fall below the refinancing rate and towards the deposit rate. Mr. Trichet indicated today that after today's policy changes the deposit rate had reached a floor at 0.25%. Unfortunately, if the ECB cuts the refinancing rate much further the gap between these two official rates might become so small that risk averse banks would place money with the ECB rather than sustain the interbank market by lending these funds to other financial institutions. Again, it is impossible to say in advance how small the gap might need to be in order to cause this to be a major problem. Again the ECB seems too intent on erring on the side of caution in this regard. This emphasis on the gap between the refinancing rate and the deposit rate also reinforces the view that a cut in the refinancing rate to 1% would almost certainly mark the lowpoint in the interest rate cycle. If further policy support is required beyond this, it will come from further non-standard measures. Next month we should learn a good deal more in this regard.

Whether the ECB will extend the maturity of its refinancing operations, broaden its collateral and/or start purchasing corporate bonds/commercial paper will now increasingly depend on the lending behaviour of the banking sector. In the statement, the ECB interestingly didn't repeat that 'the monetary transmission mechanism isn't significantly hampered', but suggested that both demand and supply factors have contributed to the substantial slowing in lending growth.

Regarding trading, by leaving its options very much open, the ECB has created a lot of uncertainty. Within this environment we can expect much more volatility on the European bond market, but we see no reason to change tack. We still feel comfortable with our buyon- dips approach. The recent lows at 122.11 and ultimately at 120.37 in the Bund should still be considered as good entry levels to go long, while on the upside the 124.70/125.63 area has become even tougher to break above. At the short end of the curve, the ECB decision to lower the repo rate by only 25 basis points shouldn't be exaggerated, as the deposit rate has become the increasingly important barometer for money market interest rates. Also in the case the ECB would have cut the repo rate by 50 basis points, the deposit rate was expected to fall to 0.25%. As such, we see only limited room for shortterm yields to move higher and would consider levels at around 107.82 in the Schatz as interesting levels to install new long positions.

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.