Flash Comment - ECB preview: Q&A to focus on QE

• We expect the ECB to keep its refi rate unchanged at 1.00% at its monetary policy meeting tomorrow. However, there is a small possibility of a rate cut. Attention at the press conference will be focused on the government purchasing programme.

• ECB President Trichet is unlikely to say too much about the details of the programme in order to keep the ECB’s options open. He could indicate that the programme will stop if market conditions improve. We expect Trichet to downplay internal ECB conflicts. A lack of further details about the programme could push German bond yields lower and lead to a widening of PIIGS government sovereign spreads.

• Due to the escalation of the sovereign debt crisis, we think the ECB will announce an additional LTRO with full allotment as last year’s one-year LTRO (EUR442bn) is due to mature at 1 July. A new one-year auction is a possibility, but shorter maturities cannot be ruled out.

• We expect the quarterly ECB staff economic projections to include a minor upward revision of the 2010 GDP projection while we do not expect any change to be made to the 2011 projection. The inflation outlook is likely to remain broadly unchanged too.

• The decline of the euro is expected to continue and we find it difficult to see what the ECB can say to talk the euro stronger right now. The weakening of the euro is not a problem for the ECB at the current point in time.

ECB engaged in credit easing since last meeting

A lot has happened since the previous meeting on 6 May. While the ECB did not even provide verbal support to the debt-troubled markets at the press conference (see Flash Comment – ECB meeting: Not even verbal support), it decided a few days later to engage in large-scale credit easing as a complement to the political agreement to set up a European Stabilisation Mechanism (ESM) worth EUR720bn (read more about the ESM here).

At the press conference tomorrow, the ECB is expected to elaborate on its decision to engage in further credit easing. There are likely to be many questions in the following Q&A session about why the ECB dramatically changed its course in just three days. Mr Trichet is likely to reiterate that the debt crisis is a fiscal problem that needs a fiscal solution. Hence, he is also likely to more or less implicitly say that the ECB would not engage in credit easing before it saw what fiscal policymakers would agree on in terms of bringing aid to debt-troubled countries in the euro area.

Mr Trichet is likely to make an effort to give the impression that the ECB did not dramatically change its course between Thursday 6 May and Sunday 9 May, and he will probably put emphasis on the fact that fiscal consolidation is now being front loaded in a number of European countries.

Bond purchasing programme burdened by ECB conflicts

The ECB announced early on 10 May that it would buy government and private debt. As market conditions had deteriorated sharply following the ECB meeting three days earlier, the ECB was in the market already from the morning on Monday 10 May, where it bought government debt issued by Greece, Portugal and Ireland. This supported PIIGS government debt markets and spreads to Germany narrowed significantly.

The ECB has purchased around EUR40bn government bonds through this programme, which it sterilises through one-week term deposits. ECB activities have declined since the first week, and spreads have consequently widened again, as there are very few buyers in the market besides the ECB. It seems a bit pseudo that the ECB sterilises the buy-up through short-term deposits, since at the same time it has provided additional liquidity worth more EUR55bn through its liquidity operations (MRO, LTRO, marginal lending). We could see the ECB being forced to expand its buying-up to outside Greece, Ireland and Portugal. Italy and Spain are likely candidates for this as bond spreads in these markets continue to widen versus Germany and liquidity continues to be poor.

Meanwhile, German bond yields are trading at all-time lows. The ECB might also be forced in the near future to engage in more full-scale quantitative easing in order to support European government debt markets if market conditions worsen further. Nobody, besides Bundesbank, really fears hyperinflation in the current situation. The biggest risk currently seems to be the dysfunctional nature of the European government debt markets. There are clear disagreements within the ECB Governing Council regarding the bond purchasing programme. German Bundesbank President and member of the Council, Axel Weber, expressed his concerns about the buying already on 10 May. Mr Weber voted against initiating a purchasing government bonds. He was supported by Jürgen Stark, member of the ECB’s Executive Board, and Nout Wellink, president of the Dutch central bank, but they are outnumbered within the ECB’s Governing Council. However, the obvious conflicts are working against the ECB and its purchasing programme.

In this respect, recent comments from Axel Weber, who said that “These operations (purchasing government bonds) should have the character of a bridge facility until the financing facilities of the EU and special purpose vehicles (SPV) take over” are not helping. His comments are disturbing in our view, since the objective of the SPV is to cover financing needs of euro area member states in difficulty and not to go directly into the market and buy existing debt, which is the objective of the ECB government bond purchase programme. Such comments do not help market conditions and are likely to be questioned at the press conference.

Further, the German magazine, Der Spiegel, recently ran stories that the Bundesbank is unhappy that French banks are using the EDB’s debt purchase programme to offload troubled debt assets. There have also been stories in international media about an upper limit to the purchase programme. These stories are working against the ECB, and one might argue that the ECB could have obtained a better result for the buy-up programme if it had kept internal conflicts within the ECB.

Market participants are currently worried about whether the ECB will indeed continue to buy up government debt, when needed. We fear that the ECB will deliver less information about its government purchasing programmes, and this will increase market nervousness and consequently lead to wider sovereign spreads in PIIGS.

The EUR442bn question

Last year’s huge one-year auction (LTRO), at which banks borrowed EUR442.2bn, is maturing on 1 July. In March the ECB said how it will smooth liquidity conditions. The ECB will carry out an additional six-day fine-tuning operation (fixed rate, full allotment) with settlement on 1 July and maturity on 7 July, the latter date coinciding with the settlement day of the next main refinancing operation (MRO). This will work as a bridge facility to the three-month LTRO which will be held on 30 June 2010. The three-month LTRO will be at fixed rate and with full allotment. The high level of deposits at the ECB of EUR351bn will also work as a buffer and smooth liquidity conditions. However, we think that the expiry of the one-year LTRO is likely to reduce overall liquidity somewhat as the demand from healthy banks will be much smaller than one year ago as these banks can get funding cheaper through the market than at the fixed rate at the LTRO. This ‘drain’ of liquidity could push up short-term money market rates. It is quite uncertain, though, since we do not know exactly how much money will leave the system after the LTRO due to the lower demand from healthy banks. If money market rates were to rise, this would challenge the ECB as it would be seen as a new sign of stress and it could eventually trigger a cut in the refi rate in order to lure back demand from healthy banks and get enough liquidity back in the system to keep short-term money market rates down.

Due to the escalation of the sovereign debt crisis and risks surrounding banks in e.g. Spain and Greece, we think the ECB will announce an additional LTRO with full allotment. A new one-year auction is a possibility, but shorter maturities could also be the case.

Will the ECB ever hike?

We do not foresee an ECB hike until H2 11. This is earlier than the market pricing (around Q1 12), but later than the Reuters poll consensus expectations of a first hike in Q2 11. There are several reasons not to expect an ECB hike any time soon. (1) Fiscal consolidation is crowding out monetary tightening. (2) The ECB has several non-standard measures (full allotment, bond purchases) that it will probably prefer to remove before starting to hike rates. (3) Normalisation of EURIBOR rates will work as an implicit hike. (4) Monetary developments remain subdued although household loans for house purchases are picking up. (5) Inflationary pressures remain low. A rate cut at this meeting is a possibility discussed in the market, but we fail to see why the ECB would go below 1% now, when it has not done so on previous occasions. However, it cannot be fully ruled out given the market system. A rate cut would be supportive for the Southern European banks, which have nowhere else to go for funding than the ECB.

New staff projections

The quarterly ECB staff macroeconomic projections are unlikely to include any major changes. The low GDP growth in Q1, just 0.2% q/q, was probably much in line with ECB expectations. The ECB projections for the rest of 2010 might be revised upwards given very strong German data and a maturing recovery in France. Due to the substantial uncertainty resulting from the Southern European debt crisis, any upward revision to the growth estimate will be small. A GDP growth estimate around 0.9-1.0% in 2010 seems likely. Fiscal tightening is dampening the growth potential in 2011 and we expect that the ECB will keep its growth projection essentially unchanged at 1.5%. The risk of downside revisions is larger than the upside risk.

The inflation outlook remains broadly unchanged too. Core inflation is likely to stay below 1% throughout 2010. Global growth momentum remains strong and we expect this to be reflected in rising commodity prices over the forecast horizon. If the debt crisis escalates further, there are downside risks to the current projections.

EUR/USD decline is not an issue yet

The decline of the EUR is expected to continue and we find it difficult to see what the ECB can say to talk the euro stronger right now. Any talk about central bank intervention to prop up the euro will be disastrous in our view as it could fuel speculation that the euro is falling apart. EUR/USD is at lowest levels for roughly four years and the European single currency has depreciated around 15% in trade-weighted terms since the beginning of the year. However, from a fundamental perspective, the euro is not particularly undervalued.

We expect Mr Trichet to signal that the weaker EUR is not a problem for the ECB, and European administrations are probably relatively relaxed about the decline of the euro and are appreciating the lift to the recovery from recent movements in currency markets. It is not that long ago that the ECB expressed concerns about the strength of the European single currency. The decline in the euro could however at some point pose a problem if volatility remains at current levels for a prolonged period or even rise further.