• Home ::
• Fundamental ::
• Analysis Reports

• Send
• Print
• Add To
• Rss

Friday Notes

2eef13aa-a6f1-4cd6-953b-62fc7a23fc09

2

0

The week of the central banks

Fri, Nov 6 2009, 12:23 GMT
by UniCredit Research

UniCredit Group

• Exit. A rapid removal of ZIRP by major central banks is not imminent. Factors arguing against this are doubts about the sustainability of the economic recovery, low (core) inflation and stable inflation expectations, as well as the strong headwinds impeding consumption and investment. There are, however, growing signs of a (verbally prepared) gradual scaling back of the more-than-generous liquidity supply measures.

• Fed. The Federal Open Market Committee probably had an intense discussion of the exit and communication strategy. The press release was, however, more dovish than expected. Markets then priced out an initial rate hike in April 2010 again (cf. chart) and are steadily falling into line with the key rate expectations for Europe. We keep our forecast of no initial Fed rate hike until autumn 2010.

• ECB. The ECB, in contrast, showed more of its hawkish side, arguing that the economic and financial environment had improved enough to start gradually phasing out the exceptional liquidity support. Otherwise, according to Trichet, there would be the threat of renewed asset bubbles. He did, however, say that the normalization must be slow and gradual. Market rates will, therefore, stay low in the coming months and the refi rate will be unchanged at 1% over the next twelve months (pages 2-3).

• BoE. The Bank of England even topped up its Asset Purchase Facility (by GBP 25bn versus the consensus expectation of GBP 50bn), following the economy’s disappointing performance in 3Q. The normalization of UK monetary policy is, therefore, likely to start even later.

• Further topics:

  – US: The near-term outlook remains positive, but ... (page 4).

  – Swiss National Bank is in no rush to tighten policy (page 7).

  – OPEC: Higher production quotas before the end of the year (p. 10)?

  – Commodity investments: Golden October (page 13).

  – Data outlook: Solid GDP growth in the euro zone (page 16).

  – Market outlook: EUR below 1.50; bonds well maintained (page 24).

Slow down! Exit ahead …

• Yesterday, Trichet signaled that the improvement in economic activity and in financial markets is sufficient to start phasing out the exceptional liquidity support.

• But he was at pains to reassure that liquidity will be drained slowly and gradually, as economic as well as market conditions allow.

• Monetary conditions will, therefore remain supportive, with market rates still low in the coming months and the refi rate probably on hold over the next year.

Phasing out liquidity support, but exit will be slow & gradual

Yesterday’s ECB press conference confirmed that central bankers are beginning to see the exit ahead, but are determined to approach it extremely slowly, to avoid the risk of derailing the recovery. It also confirmed that major central banks are ready to sign a truce with markets to avoid a head-on confrontation on the issue of asset bubbles – although Trichet was slightly more aggressive than Bernanke, and explicitly acknowledged that maintaining the current scope of liquidity support would pose a risk of bubbles and of excessive trading profits in the banking sector. The recent moderate correction in risky assets has helped defuse the situation, but the truce remains fragile. Trichet implicitly confirmed that the December 1-year Long Term Refinancing Operation (LTRO) will be the last of its kind, as the improvement in activity and financial markets is sufficient to start gradually phasing out the exceptional liquidity support. However, he was at pains to reassure that the exit will be slow and gradual, timed to economic and market conditions. Moreover, he stated that the ECB has no intention to move short-term rates away from the deposit rate (0.25%) and towards the refi (1.0%). The message, in my view, is that monetary conditions will remain supportive, with market rates still low in the coming months and the refi rate on hold throughout next year. Liquidity will be drained slowly, as market conditions allow. The fact that Trichet explicitly mentioned a scaling back of liquidity support will keep some upward pressure on EUR-USD, but not enough to break 1.50. The next test will be today, with the risk that strong US non-farm payrolls data might tempt markets to break the truce.

Trichet sounded somewhat more confident on the growth outlook, and indicated that if recent indications from hard and soft data are confirmed, the ECB’s forecasts will likely be revised upwards in December. To put this in perspective, however, consider that the ECB’s current projection of 0.2% growth in 2010 is clearly unreasonably low, and that Trichet yesterday was at pains to repeat that data are still mixed, the road as bumpy as expected, and that prudence and caution are therefore of the essence.

More significant, in my view, is that the risk of a credit crunch seems to be receding, in the ECB’s view. Trichet was very explicit in saying that the slowdown in credit growth is still mostly demand-driven, and emphasized that the most recent Bank Lending Survey points to an alleviation of supply constraints: both the decline in net tightening intentions and the resumption of positive flows in household lending are seen as meaningful encouraging signs. Trichet said it is too soon to be sure that the credit cycle has turned, but he clearly sees the picture as improving. He repeated the now longstanding call on banks to strengthen their balance sheets, but this time accompanied by the acknowledgment that markets are now more receptive to banks’ recapitalization efforts. He also reiterated that banks need to retain profits, including via more conservative compensation policies, and do their job by lending to the real economy – but yesterday’s comments if anything suggest that this already looks more rather than less likely.

Against this background, Trichet implicitly confirmed that the December 1-year Long Term Refinancing Operation will be the last of its kind – he said the market already expects as much, and he would not modify the impression. Beyond this, his comments on the next steps of the exit strategy were very prudent and pragmatic. He emphasized that the exceptional liquidity measures by definition were not meant to stay forever, but was at pains to reassure that the unwinding would be gradual and timed to reflect economic and market conditions.

Importantly, he stated that the ECB has no intention to modify the current situation that sees short-term rates like the EONIA anchored to the deposit rate rather than to the main policy rate. This suggests that the ECB is unlikely to add a spread over refi at the December 1 year LTRO, and is likely to maintain full allotment at the weekly refinancing operations.

During the Q&A, Trichet explicitly acknowledged that maintaining the current pace of extraordinary liquidity provisions (notably with the 1-year LTRO) could pose a risk of bubbles and excessive trading profits in the banking sector. This reinforces the idea that economic and financial conditions are beginning to normalize to a sufficient degree that the gradual unwinding of liquidity support needs to begin, albeit gradually. It is a meaningful admission that the risk of early bubbles features in a very concrete way in the ECB’s discussions. One issue that was left unaddressed, however, is the dichotomy that we have been highlighting within the eurozone’s banking system, with some banks still heavily dependent on the ECB and therefore more exposed to risks as liquidity support is scaled back. But here I believe the scaling back will be gradual enough to prevent serious tensions.

The December ECB meeting will be extremely important: the bank will release updated economic forecasts and probably cast more light on the rest of the exit strategy, especially as regards shorter-term refinancing operations. The outcome of the December LTRO will also give a very important signal. Trichet was hard on governments, stressing that a fiscal exit strategy is urgently needed to support confidence, and that lack of such a strategy would complicate the task of monetary policy and eventually lead to higher market rates and therefore higher refinancing costs for public and private sector alike – including because of possible rating downgrades.

• Download Full Friday Notes

Published on  Fri, Nov 6 2009, 12:23 GMT