Sunday, July 5, 2009

FX Briefing : Concealed Rate Cut - ECB


  • Job losses continue in US, employment falls by 467,000 in June
  • ECB displays concern about credit growth
  • ECB "happy" with one-year tender, not planning to actively reduce excess liquidity

The prevailing mood in the equity markets was favourable, and against this backdrop, EUR-USD strengthened somewhat up until the middle of the week. The single currency was mostly above 1.40, and even touched 1.42 temporarily. The movement was volatile, however.

The optimists referred primarily to the sustained improvement in the various surveys, e.g. the EU Commission's Economic Sentiment, the US ISM index and, last but not least, the Chinese purchasing managers' index.

On the other hand, however, there were also negative reports: consumer confidence in the US deteriorated quite significantly in June, particularly because of worries about jobs. The ADP indicator sounded a warning on the future development of employment. Despite good production and foreign trade figures for the second quarter, the improvement in the Tankan, the Bank of Japan's quarterly survey of business sentiment, was far less than expected. And in the eurozone, after the release of the latest data on money supply and credit development, fears that credit supply to the corporate sector could be inadequate intensified.

However, it was the US labour market report that really darkened the mood. After the ray of hope in May, when employment had "only" fallen by 345,000 (now revised to 319,000), job losses accelerated again in June. A total of 467,000 jobs were axed last month, over half of which were in the service sector. The unemployment rate rose to 9.5%. Under the impact of these figures, equity markets buckled and so did the euro. EUR-USD dropped to 1.40, thus ending the week on the same level as at the end of the previous week.

ECB: Actions speak louder than words

At first glance, the main messages in the ECB Council's July statement are more or less the same as the previous month: the Council still considers its monetary policy "appropriate"; it still sees growth and price risks as "balanced", and it still expects an economic recovery to set in around the middle of 2010.

Nevertheless, the bond markets' reaction to the statement and Jean-Claude Trichet's remarks was bullish, whereas EUR-USD weakened. In our view, the markets' reaction can be put down to two factors: firstly, the one-year tender, pumping a staggering €442bn of liquidity into the market, and secondly, credit development, which is apparently now starting to worry the ECB too.

In the wake of the ECB's first one-year refinancing operation last week, there was an unexpected sharp increase in credit institutions' liquidity supply. Due to the liquidity glut in the money market, the overnight call rate fell to around the ECB's deposit facility rate, which is currently at 0.25%. All in all, money market rates at the short end were pushed down significantly - below the repo rate. At the same time, a considerable amount of liquidity - to date almost €290bn - was placed in the deposit facility.

At the press conference, ECB president Jean- Claude Trichet signalled that the ECB was not planning to intervene actively to reduce the excess liquidity. Instead, Mr Trichet emphasised that the ECB was content with the result. The central bank is expecting the liquidity glut to diminish in the course of time, presumably as less use will be made of shorter-dated refinancing operations.

In actual fact, the ECB has thus implemented a rate cut: although it has not lowered the refi rate, it has significantly extended the period for which refinancing at this refi rate is available, and linked the overnight call rate, which used to be close to the refi rate, to the deposit facility rate, which is lower. Currently over 80% of central bank money allocated to credit institutions is on the basis of long-term refinancing operations, about 50% is covered by the new one-year tender.

Furthermore, the ECB governing council is seeing credit supply to the economy in a more critical light. Last month, the statement still contained the "optimistic" view that weak lending partly reflected companies' lower need for working capital. This explanation is no longer given in the latest statement. Instead of this, ECB president Trichet appealed to the banks to fulfil their obligation to supply credit. Remarks made by Bundesbank president Axel Weber also fit into this picture: he had indicated that if there was no improvement in credit supply, measures bypassing the banks might be necessary.

ECB representatives often make hawkish comments. Their actions reveal, however, that they do not think the situation has eased. In the last few weeks, there had been some speculation about interest rate hikes, but the ECB is still nowhere near the beginning of a tightening cycle.


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