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ECB in no hurry

Mon, Nov 2 2009, 10:38 GMT
by UniCredit Research

UniCredit Group

Euro Thoughts Nov 2-6 2009

Another week of upbeat evidence paves the way to the November ECB meeting where no major surprises are expected. We are currently flooded with several signs of recovery: the large increase in August IP implies a strong rebound of the manufacturing sector in the third quarter; qualitative indicators such as the composite PMI – constantly edging up – and the EC economic sentiment – which last Friday posted a healthy rise – indicate that economic activity is still expanding in the current quarter, although probably at a slower pace than in the prior three months. The latest ECB’s Bank Lending Survey (BLS) depicted a further tightening of credit standards in the past quarter but, for the first time since the beginning of the crisis, signaled banks’ intention to ease conditions in the last three months of the year.

Meanwhile, the (short) age of negative inflation is about to end. There is a strong case that in November the plus sign will show up again in front of yearly prices growth. Nothing new, all as in expectations and with no upside risks in sight: core inflation should stay very tame, progressively declining, over the next fifteen months.

For what concerns upcoming economic releases, this week is very light in terms of data, the most relevant one being German factory orders for September which, contrary to the consensus, we expect to suffer from a technical correction after that in August large tickets were crucial for the strong performance. The ECB meeting shouldn’t be particularly exciting either; however, it will be interesting to see how the Council intends to convey messages on key factors to markets given that everybody out there expects big news on the ECB’s (exit?) strategy for 2010 to be communicated in December.

The ECB “waits and sees” before the December’s breaking news

In my view, the most important event of last week was the speech delivered by Bundesbank’s Axel Weber in Berlin. In a nutshell, Weber claimed that unconventional measures will likely be rolled back in 2010. However, it would be counterproductive to define now a precise timing for the exit. In any case, the exit would be gradual and he clearly stated that, for instance, the full allotment policy for main refinancing operations (MRO) should, judging by today's perspective, surely be kept in place for longer than the very long-term liquidity injections, which are likely to be the first measures to be withdrawn. Weber’s remarks are very important because it is the first time that we hear loud and clear that in the ECB’s mind the “full allotment” procedure cannot be unwound anytime soon.

We are in the process of sketching our idea of how the ECB will likely reverse extraordinary measures in the money market next year. We will publish a detailed note shortly but, for the time being, we can at least maintain that two things will most likely happen:

1. The December one is bound to be the last 12-month refinancing operation. Plus, the ECB will probably announce a much lighter schedule for other longer-term refinancing operations, starting probably with those at the 6-month maturity. This is a key step in a prospective exit strategy. We have long argued that longer-term operations (from one month to one year) have become the crucial funding source for banks, much more than the typical weekly MROs.

As a result, the ECB is currently lending a cumulative amount of about EUR 690bn. True, the amount allotted at longer maturities progressively declines, with a net aggregate drain of liquidity, but the outstanding amount remains large and there is more than a mere suspect that a number of banks are still heavily reliant on ECB’s funding.

2. The decision to keep in place the full-allotment procedure implies that the euro area money market will keep experiencing excess liquidity and that the EONIA rate will stay closer to the deposit and below the official refi rate.

Coming to the other hot issues the Council will debate, we do not expect President Trichet to step up rhetoric on the exchange rate, although the ECB is aware that we are flirting with the pain threshold for euro area exporters and that the strong currency is one of the largest clouds on the horizon of the recovery.

As in recent meetings, on the assessment of the credit cycle President Trichet will face the trickiest task. ECB’s figures have finally certified that in September annual growth in loans to the private sector has turned negative, driven by the prolonged fallout in lending to corporates. Despite first positive signals from the BLS, the cumulative tightening so far remains by all means heavy; the IMF has recently maintained that eurozone banks have so far sustained only 40% of their potential losses; and it is difficult to foresee a nice rebound in the demand for credit amid lingering uncertainty on the sustainability of the current upswing. Bottom line: the credit channel remains impaired and threatens the recovery.

It is true that, more than the next one, the December meeting promises to be exciting. But it will mainly be on money market issues. The ECB approach on GDP/inflation prospects will remain very cautious for a much longer time. We are at the beginning of a long and bumpy road to a full recovery.

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Published on  Mon, Nov 2 2009, 10:43 GMT