ECB on Hold as the Economy Gradually Improves

• We expect the ECB to adopt a wait-and-see approach at the Governing Council meeting. Macro data appears to have stopped deteriorating and market sentiment has improved in recent weeks. If a slow economic recovery materialises, as we expect, the ECB would be unlikely to cut rates further, but would probably keep the refinancing rate at 1% for a prolonged period.
• The 36-month LTROs announced at the December Governing Council meeting combined with a substantial easing of capital requirements was the most ambitious move from the ECB to combat the crisis so far. Until the ECB has had some time to assess how successful these measures have been, we do not expect new non-standard measures to be announced.
• Market reaction is set to be moderate if the ECB keep rates unchanged while a rate cut could pull short rates somewhat down.

ECB likely to be on hold

We no longer expect the ECB to cut rates further. Our reasoning is based on the following observations:

1. It appears that economic data has stopped deteriorating and in particular US data is showing signs of a recovery. We expect a decent recovery in the US and Asia which should cause a slow economic recovery to materialise in the euro area too – albeit with a lag. Euro area PMI new orders bottomed in October and German unemployment fell to a record low in December.
2. Market sentiment has improved since early December with e.g. higher share prices and lower government bond spreads in the short end.
3. Banks took a massive EUR490bn at the first 36-month LTRO. We think the ECB would prefer to have some time to assess the impact of this important measure (as well as the second 36-month LTRO scheduled for 29 February) before it potentially delivers more easing measures. The tightening of government bond spreads in the short end suggests that the manoeuvre has indeed been successful.
4. Higher oil prices in combination with a weakening of the euro have put some upward pressure on inflation, which is now set to remain above 2% until September 2012. The recent weakening of the euro has also further eased the Monetary Conditions Index, which reduces the need for further rate cuts.
5. Finally, at the December Governing Council meeting, a 50bp cut was not discussed and apparently some members of the Governing Council were not in favour of a 25bp cut.

Risks to our forecast are tilted to the downside. Our models signal that a rate cut is still a possibility, but is unlikely to materialise at this Governing Council meeting. Our speed limit approach signals that the ECB should probably cut rates, but not before February, while a Taylor rule based on core inflation signals that ECB should be on hold.

The ongoing global recovery is in its earliest phase and is very fragile, so a rate cut in the coming months cannot be ruled out if the economic situation deteriorates again. Monetary developments remain sluggish and there is plenty of room for a final 25bp rate cut if needed. Indeed, most analysts expect a rate cut in the first quarter of 2012.

SMP programme continues

The ECB will continue to buy government bonds under its securities market programme, but we do not expect any new announcements. We believe that the ECB will continue to defend an informal cap on 10-year Italian and Spanish government bonds. Defending a formal cap would demand much smaller quantities of ECB government bond purchases than defending an informal cap as confidence would be restored much more quickly (almost instantly) if a convincing cap is announced. But the ECB appears to be more focused on the moral hazard problems attached to giving formal guarantees than whether this would be the cheapest way to achieve the objective of stopping the debt crisis; so for now we expect the ECB to continue its purchases without announcing any formal targets. If the situation deteriorates significantly and core countries are affected more heavily, a formal cap could eventually be announced.

Market reaction

To judge the expected market reaction one has to look at what is priced in for ECB cuts, which currently is difficult to assess. EONIA rates are already very low and close to the deposit rate (0.25%) due to the massive liquidity injection. We expect limited impact on EONIA rates should the ECB leave the refi/deposit rates unchanged. However, should the ECB signal no further cuts, we would expect some disappointment in the markets. A cut in the refi rate and an unchanged deposit rate is however expected to put slight downward pressure on EONIA rates as it increases the chances of a future cut in the deposit rate. Further, a cut in the refi rate is expected to have a downward effect on Euribor fixings, as given the current pace of decline in the fixings we see no cuts being priced in on the ECB January meeting.

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