ECB Could Cut Interest Rate On Thursday (And Its Impact On The Euro)

Includes: FXE
by: John M. Mason

Will the European Central Bank lower its interest rate on Thursday?

Nothing seems to be going well for the eurozone these days. And the staying power of any optimism that is generated seems to decline with each new positive announcement.

Wolfgang Münchau writes in the Financial Times: "Have you noticed that the half-life of eurozone optimism is getting shorter?"

Well, the economic news coming out of Europe is not that good and there is some betting that Mario Draghi, the president of the ECB, who has promised to do just about anything to resolve the crisis in the eurozone, will lead the central bank to another reduction in its interest rate.

Manufacturing data released today show that manufacturing activity in the eurozone stayed relatively flat but also remained below 50, which is not a good sign. The figure came in at 46.1 in September, up from 45.1 in August, but this was the 14 straight month that the number came in under 50. Not a good sign.

The data for individual countries present some new worries. The largest economy in Europe, Germany, "painted a picture of sustained contraction." But even more worrisome is the figure for France, the second largest economy in Europe: the PMI in France took one of the biggest one-month declines in the history of the survey from 46.0 in August to 42.7 in September. This is the lowest the index has been in France since April 2009.

In Italy and Spain, the third and fourth biggest economies in the bloc, the PMIs stayed firmly below 50.

On Monday, September unemployment figures were released. The figure was at historical highs for the eurozone, 11.4 percent. Furthermore, the unemployment figures for both July and August were also revised upwards to 11.4 percent. Not a good sign.

Spain remains the worst off. The Spanish unemployment rate was reported to be 25.1 percent, with 52.9 percent of people under 25 years old being classified as unemployed.

In addition, a misunderstanding seems to exist between what ministers from Italy and Spain took from a June 29 summit and what ministers from Germany believed happened. These differences in interpretation have to do not only with the formation of a eurozone banking union but also have to do with a movement toward a fiscal union in Europe.

My reading of this is that Germany holds most of the cards and that the other eurozone nations have not really accepted the fact that they have severe problems they need to overcome before any agreement can be reached for either the banking union or the fiscal union. In recent weeks, Spain has been particularly reluctant to accept their situation and cooperate. In this respect, France is, sooner or later, another problem to banking and fiscal unification.

So, Mr. Draghi, the Ben Bernanke of Europe, to the rescue. Nothing like more monetary ease to resolve the economic problem!

But monetary policy seems to have "run out of steam." And this applies to the United States as well as to Europe.

Maybe it is time to realize that the problems are deeper than the ones that a monetary policy can ease. Maybe the problems have to do with insolvency and a misallocation of economic resources.

We learned last week that the Spanish banks need only a little less that $70 billion in new capital to be considered adequately capitalized. The figure was expected to be at least $10 billion higher.

Supposedly, the stress tests applied were stricter than the earlier stress tests applied to all the banks in the eurozone. Why isn't there much confidence in this assessment? Maybe it is because the whole stress-test exercise if flawed.

Whatever, the Spanish banks are undercapitalized and need a substantial amount of capital. The next issue concerns the source of the new capital? And there is the issue of "legacy" assets, those bad assets that were on the balance sheets of the banks before the bailout question surfaced? Solvency questions do not just go away! Someone has to pay!

In Spain, the solvency problems extend to regional political areas. And, these solvency problems also related to national unity problems. The largest political and economic region in Spain, Catalina, wants to leave the Spanish nation.

And, this gets into the structural problems.

With more than 25.0 percent of the labor force unemployed in Spain, and about 53 percent of the people under 25 years old unemployed, there is obviously some structural problems that exist in the Spanish economy.

But, this is true for a large portion of the eurozone, especially in the Southern parts. Labor productivity is low, capital utilization is low, labor unions are too powerful, governments are corrupt, and so on and so forth. There are huge structural issues that must be resolved before these economies can become competitive and carry their weight in a politically and economically unified Europe.

Monetary policy is not going to solve these problems. And these problems are not going to be resolved over a short-period of time. The can has been kicked down the road for too long.

And the euro? Further cuts in the ECB interest rate are not going to turn around the solvency and restructuring problems. I think it is very clear that all the ECB has really accomplished over the last year or so has been psychological. But, as Mr. Münchau writes in the Financial Times, the impact of these psychological "lifts" are getting weaker and weaker.

"If the ECB decides to cut rates on Thursday to boost growth, 'the euro would drop like a stone,' said Greg Anderson, head of G-10 strategy for the Americas at Citigroup."

Here the loose monetary policy of the ECB combats the loose monetary policy of the Federal Reserve System. It seems like both of these central banks are competing with each other to see who can do the better job in devaluing its currency.

This time around there may be an opportunity to short the euro.

Note: China's manufacturing activity rose to 49.8 in September, up from 49.2 in August. Remaining below the break-even mark of 50, it signaled a continued mild contraction in growth for China.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.