ECB's Velvet Glove Will Undermine Euro

Includes: EU, FXE
by: Tim Clayton

The ECB is likely to strike a dovish and downbeat tone on the Euro-zone economic outlook at this week's policy meeting which will undermine the euro. The bank is also likely to cut benchmark interest rates or signal a cut next month, inflicting further currency damage. Given banking-sector stresses, it will also be forced to engage further in the structural Euro-zone debate by promising improved transmission of monetary policy while insisting on safe-guarding a longer-term commitment to monetary principles in order to keep the Bundesbank onside. With the euro likely to drift weaker ahead of the meeting, look to sell ahead of Thursday's announcement and aim for trailing-stop protection into the decision.

There is unlikely to be much in the way of Draghi's positive contagion at this week's ECB policy meeting. The economic trends have been weaker than expected as a fresh sense of gloom has descended. There was a fresh decline in the German IFO index, although the ZEW index did record a monthly gain.

Principal concern surrounded the latest flash PMI release which registered a renewed decline in the manufacturing sector and a deterioration in services. The manufacturing index fell to 46.6 from 47.9 while the services sector dipped to 46.5, the weakest reading since November. There is an important risk that the indices will have fallen further in the final reading given the Cyprus situation.

There have been some additional warnings with the Belgian business confidence index at a five-year low. Money supply and bank lending growth remains weak. Euro-zone lending has also continued to contract. The peripheral economic situation remains grim with unemployment continuing to increase as economies remain locked in a negative feedback loop.

Given that there was a discussion of interest rates at March's meeting and that conditions have deteriorated since then, there will certainly be important calls for a rate reduction at this meeting.

The ECB will have little confidence that a cut in benchmark interest rates will have a major impact given that money-market rates are already extremely low, but a move would provide some support at the margins, especially if the euro is weaker.

The banking sector will be an extremely important focus both for the markets and ECB. Indeed, this is likely to be a critical policy area over the next few months. Following the enforced haircut on Cypriot bank deposits above EUR100,000, which for the Bank of Cyprus is liable to be around 60%, there will be increased fears surrounding the threat of capital flight from Euro-zone banks. Any serious decline in deposits would inevitably trigger a further cutback in lending as the vice of depression and vicious circles tightens its grip.

The ECB will certainly be extremely concerned over a fresh widening of yield spreads and an increase in borrowing costs faced by companies in peripheral economies. Draghi made key references to this problem in a recent speech. Clearly, there is a risk that impairments to monetary policy transmission will intensify again and this will also create pressure for a more aggressive ECB policy stance.

There would, however, also be severe internal divisions if the ECB attempted to bypass OMT conditions and engage in direct quantitative easing to lower peripheral borrowing costs in violation of its current mandate. Such policy action would also provoke a severe backlash from the Bundesbank and likely make bank policy unworkable.

The central bank is likely to promise an iron fist in a velvet glove approach. The ECB is likely to introduce fresh policies to improve monetary transmission, but also issue a severe warning that this will be done on the ECB's terms there will be no unlimited use of emergency funding which would maintain pressure on national governments.

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. I have no business relationship with any company whose stock is mentioned in this article.