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The European Central Bank Cuts Key Rates. Downside Risks to Economic Growth Materialize.

Giordano Lombardo
calender-icon Posted on July 10, 2012


The ECB has already made many efforts to boost the economy. What do the latest rate cuts mean? Are they just symbolic? Speaking with my colleague Cosimo Marasclulo, Pioneer’s Head of European Government Bonds, the move was largely expected and justified by the downside risks to the economy. However, he thinks it shouldn’t be seen as merely symbolic. For a start, the “reference” rate, as it is called, sets the cost that banks pay to borrow long-term funds from the ECB. More importantly, the ECB has lowered the closely-related deposit rate by a quarter-point, which is now zero. This may be taking the ECB into new territory. 

The rationale for this new unconventional policy is that banks currently parking about 800 billion euros in ECB accounts, will instead lend them to real-economy players (businesses and households).

Is there any case for other unconventional measures?

If a quantitative easing policy cannot be strictly pursued in the euro area, alternative tools may have to be found. Getting the deposit rate to zero and then eventually into negative territory, according to the ECB chairman Mario Draghi, is an additional unconventional tool that might be used shortly.

Other instances of quantitative easing or its ECB equivalent, the Long-Term Refinancing Operations (LTRO), should not be ruled out, but they are likely to be used less intensively, as we believe the unintended effects of the two very large auctions (notably the high percentage allocated to government bonds) should be avoided. Actually, the ECB chairman has talked down the need for further action of this kind.

Evaluating the ECB stance by the chairman’s speeches.

In the latest press conference, the Chairman focused on banks’ financial conditions, its main job, of course. He put less emphasis on measures to cap yields on government bonds, however. This omission disappointed some investors, who probably expected the ECB to endorse the latest EU summit agreement by buying bonds of ailing countries. However, special programs such as the SMP (purchases in the secondary market) may be a thing of the past, and also the case for another round of LTRO has not been made as the rescue funds are poised to take up this function.

Does the recent central bank activity, also outside the euro area, bear any relevance and will it affect investment decisions?

We are still in post-EU summit relief mode and this may help to see the positive side in the global mobilization of central banks (China’s rate cut, as well as the Bank of England’s further injection of funds, were decided within less than an hour from the ECB move).

In our view, investors may consider to “take risk on,” as was suggested. We agree in principle with this message and confirm our search for yields in larger EMU peripheral countries (Italy, Spain) at the expense of unattractively priced core bonds. At the same time, this mobilization suggests that there are still many uncertainties around us and we are ready to play tactically any bout of risk aversion.

 

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