Sunday, March 8, 2009

FX Briefing : ECB - Remarkably Realistic


  • ECB and BoE cut interest rates by 50 basis points
  • ECB open to further rate cuts, considering additional measures
  • US job losses continue

At first, weak economic data and the sustained fall in share prices continued to boost the dollar. In the middle of the week, USD-JPY rose to a peak of 99.68. EUR-USD slipped temporarily to 1.25. Towards the end of the week, however, a counter movement, triggered by China's Premier Wen Jiabao, set in. Although he did not confirm the rumours circulating about the economic stimulus package being extended, he did stress the government's determination to achieve its growth target of 8 per cent, despite the global economic crisis.

However, appearing as it did just before the interest rate decisions of the ECB and the Bank of England were due, this tiny spark was not sufficient to have a sustained impact on the market. After the 50 basis point interest rate cuts to 1.50 and 0.50 per cent respectively, the euro and the pound fell back temporarily. Once again, EURUSD made a brief foray below 1.25, only to retreat to familiar territory again.

Despite the risks perceived for the eurozone, the United Kingdom, Japan and other countries, market participants did not have all that much faith in the US currency either. This was understandable, as there seems to be no let up in bad news from the US. The week started with the news that AIG had made a record loss of $61bn in the fourth quarter. Then the rating agency Moody's announced that it had changed the outlook for the three largest US banks to negative. Towards the end of the week, the dollar was also weighed down by the US labour market report.

The ADP indicator and initial jobless claims in particular suggested that the unemployment rate would go on rising to record levels. In fact, a further 650,000 jobs were lost in February. Against this backdrop, EUR-USD firmed to around 1.27, USD-JPY fell back to 97.

This reaction, i.e. the dollar weakening on signs of crisis in the US, is, however, in complete contrast to the pattern of the past months, when the dollar and the yen had generally been regarded as "safe havens". After the release of the Japanese GDP data, the yen had lost this status. The dollar situation could now be returning to normal to some extent, so that bad news from the US would be bad for the dollar again. The fact that the differences in the monetary policy of the major central banks are fast disappearing would also back up this argument.

The ECB, which has up to now rather grudgingly eased monetary policy, now seems to be facing the facts. ECB staff, who are responsible for making the projections, have revised their forecasts down drastically. If, to simplify matters, we look at the middle of the ranges, the ECB is now expecting real GDP to decline by 2.7% in 2009, and to stagnate in 2010. According to the staff projections, the inflation rate in the eurozone will fall to 0.4% this year, and be around 1% only in 2010.

In our view, two points are particularly remarkable: (1) The central bank is no longer assuming that things will sort themselves out during the course of this year. A gradual recovery is now not expected to set in before 2010. (2) The ECB is seeing increasing evidence that weak demand in the eurozone and all over the world will continue to dampen inflation in 2009 and thereafter. In fact, the ECB admits that the price stability target of "just under 2%" could be undershot in the medium term.

The 50 basis point interest rate cut was in line with market expectations. On the subject of further interest rate movements, Jean-Claude Trichet was fairly tight-lipped at the press conference. He confirmed that at 1.5% there was still some scope; he did not want to commit himself to a minimum level for the refinancing rate, but commented that, at 0.5%, the deposit rate was "very very low". Given the macroeconomic risks, the ECB is evidently keen to keep all options open.

One of the options is to implement non-standard measures. According to Mr Trichet, the ECB governing council is currently discussing whether such measures are necessary and how they could be implemented. He did not categorically exclude anything, but hinted that ways of improving credit conditions were taking priority at the moment.

In our view, the ECB reached a decisive turning point last Thursday. Given the sustained escalation of the economic situation, the ECB will probably reduce interest rates further in April. In the course of the second quarter, it will presumably start implementing additional measures.


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