Seeking Alpha
Profile| Send Message| ()  

The European Central Bank cut interest rates and, after a bit of volatility, the euro (FXE) ended the week flat. The euro has been trading in the $1.305 - $1.315 range for the last month and not even a rate cut could make it move much, but the European sovereign bond and equity markets rallied on the news. The real story is that by cutting rates sooner rather than later, the ECB may be closer to enacting a non-traditional monetary policy program. Economic weakness and the Cyprus crisis have been brushed off as investors are showing optimism for Europe and bidding up European assets.

ECB Rate Cut

The ECB cut its main interest rate by 25 bps to 0.50%. It also cut the rate on its marginal lending facility by 50 bps to 1.00%.

This action was widely expected. There was a surprise as Mario Draghi said in the press conference that the ECB may consider a negative deposit rate (currently at 0%) in order to encourage banks to lend more.

The ECB has only one primary objective, namely to keep inflation stable (unlike the US Federal Reserve, which is tasked with inflation and unemployment). The falling inflation rate in the Eurozone made it easier for the ECB to act.

(click to enlarge)

(Source: ECB.int)

The ECB's ability to boost economic activity in the Eurozone is limited. Monetary policy has less of an impact on certain countries, and Europe's problems need political solutions. It is unlikely that European politicians will take action to further integrate Europe, especially the banking system, until the German election, so the ECB is the only game in town for now.

More broadly, there is a debate in Europe about austerity and to what extent Germany should foot the bill for the problems in other countries. Germany is a proponent of austerity in peripheral countries, but there is a growing sense of pushback. The Italian election results were a response to the austerity movement. Citizens in the peripheral countries do not want to face the harsh realities of austerity and want Germany to take more action to boost growth in the Eurozone.

The austerity backlash seems to be gaining momentum (especially after the Cyprus crisis), which could lead to more pro-growth policies.

The austerity vs. growth debate is outside the ECB's mandate. However, it seems that the ECB may be getting closer to take more action to help some of the struggling peripheral countries.

Now that the ECB cut rates, sooner rather than later, the timeline for additional action moves up. The ECB won't enact a quantitative easing program like in the US, but there are things it can do. If the ECB is on the side of doing more, rather than less, it would be positive for European assets.

Euro Price Action

Last week, I stayed away from making a prediction about a rate cut (ECB Decision On Interest Rates And The Impact On The Euro). I thought it may be too early for the ECB to cut rates, but I did not want to ignore the growing consensus that a rate cut was coming. However, I did say that the impact of a rate cut on the euro could be limited.

Although there was some volatility in the euro during Draghi's press conference, especially when he said that the ECB may consider a negative deposit rate, the euro was little changed on the news of the rate cut. It has been steady in the $1.305 - $1.315 range for the last month.

On a longer timeframe, the euro is stuck in the middle of its 2 year range.

(click to enlarge)

(Source: FreeStockCharts.com)

The big story in currency markets is coming from Japan, not Europe. Compared to the new Japanese QE program, the ECB's rate cut is a minor event. Furthermore, Japanese QE is adding to the global search for yield, and some global investors are attracted to the relatively high yields in European sovereign bonds. These inflows seem to help support the euro, which may otherwise be trading lower because of the continued weakness in the Eurozone.

European Sovereign Bonds

Bond yields for Italy, Spain and Portugal continued to fall last week (and prices increased). Also, spreads between Germany and the peripheral countries continued to compress.

German and French bond yields rose on the week, with most of that coming on Friday. The rise in the yields on US Treasuries (TLT) following the positive surprise in non-farm payrolls could have impacted the yields on German and French bonds. It will be interesting to see how they trade next week.

(click to enlarge)

European Equity Markets

European equity markets also rallied on the news of the ECB rate cut.

Interestingly, the German index outperformed the peripheral countries. It could be that the ECB rate cut would have more of a positive impact on Germany than some of the other countries in the Eurozone.

The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (EWG), iShares MSCI Italy Index Fund (EWI), and iShares MSCI Spain Capped Index Fund (EWP), and the SPDR EURO STOXX 50 ETF (FEZ).

EWG Chart

EWG data by YCharts

The European financial sector traded mostly in-line with the broader market.

The following compares the iShares MSCI Europe Financials ETF (EUFN) with the iShares MSCI EMU ETF (EZU).

EUFN Chart

EUFN data by YCharts

I have been following Banco Santander (SAN) as a play on the European turnaround and have a long position in the stock. (This is more of a trade than a buy-and-hold position.) Last week, Banco Santander's CEO resigned and was replaced last week (Banco Santander Names Javier Marin as CEO After Saenz Quits).

Banco Santander underperformed the European financial sector, represented by the EUFN ETF.

SAN Chart

SAN data by YCharts

Here is a look at Banco Santander's performance over the last six months.

(click to enlarge)

(Source: FreeStockCharts.com)

Impact of European Equity Markets on U.S. Equity Markets

Earlier this year, a gap emerged between the performance of the S&P 500 and its European counterparts. Some expected European equity markets to bring down US equity markets like last summer. However, that seems unlikely now as the performance of European equities is catching up to the performance of US equities.

The following compares the S&P 500 (SPY) and the Financial Select Sector SPDR ETF (XLF) with their European counterparts, the EZU ETF and the EUFN ETF.

SPY Chart

SPY data by YCharts

Conclusions

There are many reasons for the euro to fall, and the ECB rate cut could have been another catalyst. However, the euro remains resilient, probably benefiting from global liquidity and the hunt for yield that is bringing global investors to Europe. The ECB acted sooner rather than later in cutting interest rates, which may move forward the timeline for a non-traditional monetary policy. European bonds and equities are rallying on hopes of an economic turnaround. It looks like the euro could hold up a while longer and European assets may be positioned for further gains.

Disclaimer: The opinions expressed above should not be construed as investment advice. This article is not tailored to specific investment objectives. Reliance on this information for the purpose of buying the securities to which this information relates may expose a person to significant risk. The information contained in this article is not intended to make any offer, inducement, invitation or commitment to purchase, subscribe to, provide or sell any securities, service or product or to provide any recommendations on which one should rely for financial, securities, investment or other advice or to take any decision. Readers are encouraged to seek individual advice from their personal, financial, legal and other advisers before making any investment or financial decisions or purchasing any financial, securities or investment related service or product.

Information provided, whether charts or any other statements regarding market, real estate or other financial information, is obtained from sources which we and our suppliers believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Nothing in this article should be interpreted to state or imply that past results are an indication of future performance.

THERE ARE NO WARRANTIES EXPRESSED OR IMPLIED AS TO ACCURACY, TIMELINESS, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION IN THIS ARTICLE OR ANY LINKED WEBSITE.

Source: ECB Interest Rate Cut: Euro Strong And Steady, European Markets Rally

Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.