Trichet Delivers: ECB Hikes Its Interest Rate

Apr. 7.11 | About: iPath EUR/USD (ERO)

The European Central Bank raised its policy interest rate by 25 basis points this morning and, I believe, changed the game. Mr. Trichet, president of the ECB, delivered on his promise initially given in March.

To me, this is a “tipping point,” even though the Bank of England kept its policy rate constant. Other central banks around the world have been raising their policy rates over the past year but no “Western” central bank had followed.

Now, the “West” has followed and this alters, not the outlook for interest rates, but the timing of future increases.

There are three areas one needs to focus on within the current environment.

First, keep an eye on what goes on in the Eurozone in terms of country “bailouts” and the potential re-structuring of the sovereign debt within the nations of Europe.

It was not a coincidence that Portugal asked for help the day before the meeting of the ECB. Portugal has lots of debt coming due this year; its credit rating has gone through several reductions already this year; and the country is without a government and facing an election. Even Portuguese banks were saying that they would not buy any more debt issued by the government of Portugal.

Facing a “new” attitude in the capital markets and rising interest rates, what is substituting for a government in Portugal had to act. In essence, the IOUs were coming due.

And this means, I believe, that the IOUs are going to be collected elsewhere within the Eurozone. The day of reckoning has been advanced. People are going to have to do something now.

Second, watch what European banks are doing and are going to do. On Wednesday, two European banks announced their plans to raise new capital. The total to be raised amounts to about $19 billion and brings the total capital raisings announced this year by European banks to almost $36 billion.

Again, I don’t think that the timing of the announcement, the day before the ECB raised its interest rate, was a coincidence.

Furthermore, the Spanish government this week stepped up efforts to get its “healthy” banks to buy up a good portion of its “savings” banks in an effort to shore up Spain’s threatened banking industry. With Portugal now seeking help, a greater focus is going to be placed upon the fiscal health of the Spanish government and its banking system. Spain is going to move because it appears as if it may be “next in line.”

In addition, there still are the results of the recently applied “stress” tests on the commercial banks of Europe. Two things here: there is the question about how valid the tests are; and there is the response of the banks, themselves, to the results of the tests.

The European “stress” tests are already being questioned relative to whether they are strong enough to really be anything but a subject of jokes. If the tests are too weak to prove anything, then the credibility of the European regulators will suffer a serve blow at a very crucial time. This will not raise the financial markets' confidence in the European banks and the European banking system.

The European banks may have to “act on their own” to overcome this loss of regulatory credibility. The way to do that? The banks can raise a significant amount of capital on their own and take the whole question of capital adequacy out of the hands of the regulators. This may be a part of the strategy of the European banks that are now raising capital.

Third, continue to observe the behavior of the United States dollar in foreign exchange markets. My guess is that this move by the ECB to raise its interest rate will cause further erosion of the value of the United States dollar in foreign exchange markets. This move may not be immediate, but will persist over time.

By raising its policy rate, the ECB may be forcing Europe to get its act together and resolve some of its solvency and governance issues. The movement by the Portuguese is just a starting point. The movement of the banks adds momentum to the process. If this action truly brings events “to a head” then, I believe, everyone will be better off for it.

But, if Europe begins to move in the right direction, what is in store for the United States dollar?

Europe moving to resolve some of its issues will only result in more pressure for the value of the United States dollar to decline. And, this decline will only provide additional evidence that the international community has little confidence in the current leadership of the United States to really address its fiscal (and monetary) problems.

The question then becomes…will this change the nature of the discussion within the United States?

Will this twenty-five basis point change in the policy interest rate of the European Central Bank serve as an action that creates the “tipping point” for the direction of economic and fiscal policy in Europe and the United States?

I’m sure that the wily Mr. Trichet would like to see this happen.

I’m not sure that the former professor of law from the University of Chicago and the former chairman of the Princeton Economics Department would agree.