Monday, November 1, 2010

ECB: Rendez-vous in December

The 4 November ECB meeting is going to be fairly uneventful. For market-sensitive announcements, the
"rendez-vous" is in December.

  • Business surveys keep providing reassuring evidence on the health of the eurozone economy. If anything, they indicate some upside risks to the ECB’s GDP projections for the final part of 2010.
  • M3 and loan growth remain subdued, but the first positive signs on corporate lending will probably make the ECB more confident that the credit cycle is about to turn. The October Bank Lending Survey confirms the picture of moderate improvement.
  • Recent developments on the liquidity front support our view that the ECB will drop the full-allotment on 3M LTROs at the December meeting.
  • The ECB has done nothing to hide its disappointment on the agreement reached by euro area finance ministers on the reform of economic governance. This will probably be a topic of discussion during the Q&A session.

Expect no major news on 4 November
The 4 November ECB meeting is unlikely to bring major news – for market-sensitive announcements, the "rendez-vous" is in December, with the publication of updated macroeconomic forecasts (including for the first time the estimates for 2012) and new details on the liquidity strategy. Next week, Trichet should confirm that the central bank remains cautiously optimistic on the area’s growth prospects, with higher interbank rates seen reflecting the ongoing process of normalization in the financial sector. The ECB’s disappointment
about recent proposals to reform economic governance in the euro area will probably be a topic of discussion during the Q&A session.

Economic and monetary analysis
On balance, the October round of business surveys provided reassuring evidence on the health of the eurozone economy, validating the ECB’s assessment that the recovery remains on track. If anything, the most recent growth data indicate some upside risks to the central bank’s GDP projections for the final part of 2010. The renewed acceleration in the German Ifo to the highest level since mid-2007, with a surprising rebound also in the expectations index, points to an increasingly sustainable upswing in the largest economy
of the area. This helps further reduce the (already low) probability that the eurozone will face nasty GDP surprises down the road. Even the growth implications of the recent euro appreciation should not be overestimated, in our view.

This is because prospects of further expansionary measures by the Fed – the key driver of USD weakness since the end of August – led to a generalized increase in equity prices and a drop in volatility and corporate bond spreads, which will probably suffice to neutralize some of the damaging growth
impact of a stronger euro.

Coming to the monetary analysis, the main novelty is the second consecutive increase in the monthly flow of lending to Non-financial corporations (NFCs) in September, which will probably make the ECB more confident that the credit cycle is about to turn.

Although overall lending to the private sector remained very weak at 1.2% yoy and M3 growth fell back to only 1% yoy, the ECB could be temped to start sounding slightly more upbeat on the monetary pillar. The October Bank Lending Survey showed mixed results, but on balance confirmed a picture of moderate improvement.

Money market normalization
On 19 October, the 3M Euribor rate rose above the refi rate for the first time since July 2009. This adjustment, which is endogenously determined by the decline in excess liquidity and therefore contains no monetary policy signal, certifies that the financial sector continues to recover, as also shown by the fact that Spain, Greece and Portugal in September reported a decline in central bank funding.

We also point out that the upward trend in the 3M Euribor rate has tracked very closely the “fair” refi rate prescribed by our Taylor rule in response to some narrowing of the output gap and a moderate recovery in lending to the private sector. In other words, money market normalization is now fully justified by the improvement recorded both in the financial sector and the real economy. What’s more, the last leg up of interbank rates has been relatively fast, a signal that the ECB doesn’t need to be overly cautious in its exit. Note that higher demand at the last 3M LTRO (EUR 42bn bid vs. EUR 23bn expiring) is unlikely to have reflected increased money market tensions. Rather, it was probably due to the fact that the Euribor rate is now slightly above the refi rate, with risks skewed towards a further increase in the coming weeks. If anything, this suggests that the full-allotment is creating some distortions in demand for liquidity and offers arguments

for removing it as soon as possible. Although there remain considerable pockets of weakness in the banking sector of peripheral countries, our view that the ECB will drop the fullallotment on 3M LTROs at the December meeting seems increasingly fully on track.

Economic governance
The ECB has done nothing to hide its disappointment on the agreement reached by euro area finance ministers on the reform of economic governance. By de-facto leaving the decision to impose sanctions in political hands, the final accord is weak on all the main points that the central bank deemed as important to solve the problem of moral hazard, namely automatism and timeliness in the application of sanctions. This low-profile compromise puts the ECB in a difficult position: the central bank has the right to forcefully argue its point of view on economic governance issues, because it is ultimately the ECB that is left “holding the bag”,
i.e. acting to ensure financial stability: this is the case both for its enhanced liquidity support measures to help the residual pockets of weakness in the banking sector, and for the government bond purchase program. Remember that the government bond purchase program has been particularly controversial, and Governing Council member Weber has recently again called for it to be discontinued soon. Lack of significant and credible progress on strengthening the Stability and Growth Pact, instead, flags the risk that the program
might need to remain in place for quite a while longer.

Full report: ECB: Rendez-vous in December

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