FOREX TRADING

ECB Meeting: Heading for the Exit

• The ECB is now heading for the exit. For one thing they are cutting down on the longer term auctions. The 12-month auction in December will be the last of its kind and so will the 6-month auction at end-March. This is slightly more hawkish than expected.
• Markets were particularly surprised by the ECB moving away from 1% at the 12-month auction and instead applying a rate calculated as the average minimum bid rate of the weekly main refinancing operations over 12 months. Consensus expectation was a flat 1%.
• Trichet was eager to say that this was not intended as a signal of future rate hikes, but it is nevertheless likely to be interpreted as an indication that the ECB considers hikes in 2010 likely. The procedure might help to curb banks’ demand at the auction without affecting interest rate expectations as much as a fixed spread would have.
• The weekly main refinancing operations and the 1-month and 3-month auctions will be with full allotment at least until early April. We find it likely that the ECB moves away from full allotment at the 1-month and 3-month auctions in April.
• The ECB’s assessment of the economic situation is becoming more positive. Nevertheless we still consider that the ECB is too downbeat. We think that they could double their growth forecast for 2010 and still turn out to be too dovish.
• The ECB expects inflationary pressures to be low. But in their inflation projection, the upper end of their band for 2011 is nevertheless 2.0%. They will not have to revise their inflation expectations much upward before they can defend moving away from record low interest rates.
• Today’s press conference has been slightly more hawkish than we expected. It has clearly surprised some observers how determined the ECB is to move towards the exit. Nevertheless market reactions were muted – with interest rates rising ahead of the meeting on rumours that the ECB would be hawkish.

The end of long auctions

The rate in the last 12-month longer-term refinancing operation, to be allotted on 16 December 2009, will be fixed at the average minimum bid rate of the MROs over the life of this operation. Trichet said that this was not intended as a signal of rate hikes and should rather be seen as a way to have a neutral rate. It must nevertheless imply that the Governing Council finds that hikes in 2010 is so likely that it is worth making this complication – not only for themselves but also for the banks that will now have to handle their loans differently from the two prior 12-month auctions.

The ECB’s aim is clearly to curb banks’ demand for 1-year liquidity without affecting interest rate expectations. It is likely that the ECB will to some extent succeed on the first matter as the terms are certainly less favourable than the 1%. On the second matter it is more likely that they will fail. We see this as a clear signal that the ECB is heading for the exit and we think that consensus will soon agree that the ECB will not want to keep rates at a historical low beyond next summer.

The last six-month longer-term refinancing operation will be undertaken on 31 March 2010 as a fixed rate full allotment. The 1-month auctions will continue with full allotment for at least the first three maintenance periods of 2010, as will the monthly 3-month LTRO in Q1. It is likely that the 6-month auction will be on the same terms as the 12-month auction.

To keep it simple only one interest payment will be made in the 12-month auction (on the maturity date).

Full allotment could end in April

The weekly main refinancing operations and the 1-month and 3-month auctions will be with full allotment at least until early April. We find it likely that the ECB will move away from full allotment at the 1-month and 3-month auctions in April. Full allotment at the weekly main refinancing operation is likely to be kept for longer, though not beyond end-2010. It is also likely that the 1-month auctions will be terminated at the end of 2010. The ECB would then be back to its normal setup.

When moving from full to fixed allotment, the ECB could begin with large amounts.

It is worth noting that the ECB in a press release following the Governing Council meeting has written that “Looking beyond the first quarter of 2010, the Governing Council will take into account the need to smooth out the liquidity effect of the 12-month longer-term refinancing operations maturing during the second half of 2010.” This is an indication that the ECB will consider using liquidity absorbing operations maturing at the same time as the 12-month auctions. In addition they could use small allotments at auctions with maturity close to the maturity of the 12-month auctions and give larger allotments afterwards.

The ECB growth projections have become more light-hearted

The ECB’s assessment of the economic situation continues to become more light-hearted although at a slow pace. We still find that the ECB is way too downbeat. The ECB mid-range growth estimate has been revised up from 0.2% to 0.8% in 2010 and they now project growth of 1.2% in 2011. We trust that growth will be above 2% in both years. Given how much the economy has declined, even this is not a very strong rebound.

The ECB still expects inflationary pressures to be low and Trichet reiterated that rates remain appropriate. Their inflation projection for 2010 has been revised slightly up from 1.2% to 1.3% in 2010 and their mid-range expectation for 2011 is only slightly higher at 1.4%. But the upper end of their band for 2011 is nevertheless 2.0% and thus flirting with the ECB target. From this starting point they will not have to revise their inflation expectations much upward before they can defend moving away from the current record low refinancing rate.

Muted market reaction

Today’s press conference has been slightly more hawkish than we expected. The ECB’s determination to move towards the exit has clearly surprised some. Nevertheless market reactions were muted as interest rates had already risen ahead of the meeting on rumours that the ECB would be hawkish. Stock markets turned a bit sour around 16.00, which should be attributed to the ISM. As a result, interest rates then declined somewhat again.

We stick to our expectations that the ECB will begin its hiking cycle next summer.

Danske Bank
http://www.danskebank.com/danskeresearch

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