Markets Are Underestimating The Risks Of An ECB Rate Cut Next Week

by: Marc Chandler

The ECB meets next week. We suspect the market is underestimating the risk that the ECB responds to the string of poor economic data. Recall that after contracting in Q4 11 the euro area economy stagnated in Q1 12. It was Germany's 0.5% expansion in Q1 that allowed the area to avoid a second consecutive quarterly contraction.

The recent data warns that the German economy has lost some of its sizzle. The economic downturn in other parts of Europe seem to be deepening and this will likely be reflected in the PMI readings later this week.

The ECB will provide new staff forecasts at next week's meeting and the direction of the revised growth estimates is likely to be lower. With the drop in commodity prices in general and energy in particular, the staff may lower their inflation forecasts as well.

In addition, ECB President Draghi has shown he can take decisive action, like cutting interest rates at the first two meetings he chaired, completely unwinding the two hikes that Trichet had delivered earlier in 2011. His two LTROs also showed he as a man of action.

A rate cut would be meant to address the economic weakness. It is not an alternative to the sovereign bond purchases or LTRO, which are liquidity measures. While an argument can be made that the ECB would be better served to wait until after the Greek elections to move on rates, we think that confuses liquidity measures from monetary policy proper.

A 25 bp cut in the repo rate would set a new cyclical low for the key rate. This in turn would lower rates that are tied to it, like the LTRO. Such a rate cut could pose a technical challenge for the ECB. The repo rate is in a corridor with the ECB's lending rate currently set at 1.75%.

That 'could be' cut would reduce the penalty rate. It is the floor, the deposit rate, which poses the challenge. It is currently set at 25 bp. This is the rate that banks earn on their deposits at the ECB. We have argued that European banks would park their funds at the ECB even if they were not paid to do so because of their concern of counterparty risk Yet, officials may be reluctant to cut it to zero. A narrower corridor would be the result if the lending rate was cut by 25 and the deposit rate was not cut or cut by less. In either case, we do not see it as having material impact.

Disclosure: No positions