Speculation that the ECB will move to ease monetary policy at its meeting in Bratislava on May 2 has mounted after the second and third consecutive monthly declines in the German Ifo and purchasing managers’ indices cast doubt over the health of the eurozone’s economic engine.
That talk has been given added impetus by comments from arch hawk Jens Weidmann, Bundesbank president and ECB council member, who said last week that a rate cut was possible “if the data warrant it”.
With German economic data disappointing, it seems therefore that ECB policymakers have the green light to cut rates.
| Weak April eurozone PMI raises pressure for ECB refinancing rate cut |
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Deutsche Bank expects the ECB to cut its refinancing rate from 0.75% to 0.5%, but believes the deposit rate will be kept at 0%, given that resistance to a negative policy rate within the central bank remains high.
Mark Wall, economist at Deutsche, says the ECB council probably knows that more than a 25 basis point cut in the refinancing rate is required to put the eurozone economy back on track.
“With only 75bp of refi rate potential before hitting the zero nominal rate bound, the council is likely to favour two quarter point cuts, one in May and another to follow in the summer,” he says.
Wall believes that to maximize the potential from conventional monetary policy, the ECB might also turn to forward guidance, a shift that would contradict its historic mantra of “no pre-commitment” on rate moves.
“A virtual zero policy rate with forward guidance might be the most that conventional policy has to offer the ECB,” he adds.
The problem for currency investors, however, is that it is not immediately apparent that a cut in conventional monetary policy will push the euro lower in the medium term.
On the one hand, a rate cut would put downward pressure on the euro, but on the other, the ECB will still have the tightest monetary policy in the G3. Some believe that, combined with an ever-increasing trade surplus, could see the euro surprise to the upside in the second half of the year.
Neither is the initial reaction to the ECB’s policy meeting clear cut.
A rate cut on its own is likely to provoke short-term weakness in the euro. However, if a cut in the refinancing rate were to be combined with some form of easing measure to try to improve the flow of credit to the periphery of the eurozone, the ECB decision could support the single currency.
Aditya Bagaria, strategist at Credit Suisse, says given the uncertainties surrounding the reaction of the euro to the ECB decision, it might be better for currency investors to play the weakening economic eurozone data through the euro satellite currencies, which are geared to growth in the core of the single-currency bloc.
He says weak German data also increases the risks to growth in those satellite countries, making Scandinavian currencies and the CE3 currencies – most notably the Polish zloty – look vulnerable.
Since the start of the eurozone debt crisis, positioning for the underperformance of Scandinavian and other euro satellite currencies based on weaker eurozone growth has proven challenging, according to Bagaria.
“Despite the downside risks to the growth outlook and the risk of dovish policy driving rate differentials against them, some of the satellite currencies benefited from the store of value and reserve manager flows as systemic stress across the eurozone intensified,” he says.
| Peripheral eurozone bond spreads tighten despite growth slowdown |
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In the current economic slowdown, however, there has not yet been a marked deterioration in the market’s perception of eurozone systemic risk. On the contrary, peripheral eurozone sovereign yield spreads have continued to tighten relative to those at the core of the region, while bank funding costs in the periphery have eased in the wake of the Cyprus rescue deal.
“This leads us to expect further Scandi and CE3 underperformance in the near term as weak growth in the core spills over to the satellites,” says Bagaria.
Simply selling the euro in anticipation of monetary easing from the ECB might not turn out to be the best course of action.