Will “super” mario surprise with a rate cut at todays eCB meeting?

It is a key day today for European investors with the ECB holding its second interest rate meeting of the year. Investors’ eyes will be focused on the press conference following the announcement just after midday and they wll be looking for clues regarding the near term direction of European monetary policy given the relative tightening that has occurred of late.

Analysts as a consensus don’t expect anything special to come from this event but we think there is a real chance of a rate cut. In July last year, Super Mario came to the rescue by stating he would do “whatever it takes” to save the Euro. Now it is time for Draghi to take his seat at the table in the global currency war –  a war that the US, UK & Japan are presently winning hands down. The key issue hanging over Europe and contributing to the current recession is the unwelcome Euro appreciation. By cutting 25 bps on the current 0.75% key rate, the ECB can give a clear signal to the world it will not allow growth in Europe to be sacrificed.

From Lack of Growth to a Currency War

All of the world’s major central banks have been attempting to improve internal economic conditions for their countries in the hope of sparking a return to growth. With a muted economic backdrop, and rising public debts, internal demand has been depressed right round the globe with the exception of parts of Asia & Latin America. As this has largely failed, Governments and central banks have been left with no option but to focus on external demand as a means of getting their economies back on the rails. Exports are key.

Japan, under new PM Shinzo Abe, has a renewed commitment towards depressing the yen and the FED has been pursuing the same route for the dollar with their open-ended asset purchase program for nearly 4 years now. In the UK, although the QE program by the BOE has been suspended, Mervyn King has been an open advocate of currency weakness to buffer the British economy. Even the SNB (Swiss National Bank) embarked upon its own currency weakening program in 2011, adopting a cap of 1.20 against the Euro to stem its own excessive currency appreciation.

There seems to be no other option for Eurozone countries than to engage in effective internal devaluations and which have had huge costs in terms of growth and employment as illustrated by Greece, Spain and Portugal. Unfortunately, that path is a frustrating one for its peoples as it has large risks if not accompanied by an exchange rate policy that is able to lock in any gains deriving from this hard effort. Presently the Euro strength is stopping this dead in its tracks. If the Euro continues to rise, the last few years of efforts will be jeopardised. Lower labor costs will be offset by a higher Euro and in the end Europe will be right back to square one and speculation over a break up. Draghi must know this.

How badly is the Euro appreciation affecting the Eurozone?

Before Draghi uttered those magic words “whatever it takes” that put a floor under equity markets, the euro was in fact rebasing back to something like fair value – hovering near 1.20 against the dollar and 1.30 against the pound. Since that point however, the Euro has been in a sharp uptrend. At first, it was not what Trichet would call a “brutal” movement, but since QE3 was announced by Ben Bernanke in the US, the Euro has been under sharp upward pressure. Other central banks followed the US’ move in a desperate attempt to avoid their own currency appreciations against the dollar and as the ECB began effectively tightening through its bond sell downs, upside momentum in the Euro has built.

The above table shows just how much the Euro rose, particularly against the Yen since QE3’s announcement. In just one month and a few days, it rose 6.7% against the Pound, a very unusual rate of change for such a small period and around 3% against the US Dollar. The rise against the Yen is shocking, with the Euro gaining 11.1% just this year and 26.6% since QE3 was announced in the US. Five of the six most traded Euro pairs are higher this year, with the only exception being the Swedish Krone.

Eurozone or Germanzone?

Adding to the bullish case for the Euro is the return of ECB funds by many European banks. In recent days they paid back, earlier than expected, part of the funds they received through the LTRO program. Even though that it is extremely cheap funding, it seems the stronger banks no longer require it, probably due to the poor incremental returns that can be presently obtained through investing in government bonds – the primary trade they have been embarking upon with these funds to repair their balance sheets.

The payback to the ECB has resulted in its balance sheet shrinking, and which effectively results in the ECB tightening monetary policy. Even though such a move is applauded by the austere Germans, it is a real risk for the health of the whole Eurozone. This tightening is contributing to the rise in the Euro and impacting negatively the only real driver for the European economic bloc – exports. Again, this is our central thesis as to why Draghi may surprise the market with a rate cut today.

The latest data coming out of France is so awful that Hollande has in fact put forward an urgent need to establish a policy regarding the exchange rate. That statement was immediately repudiated by Germany – being the Euro member it seems advocating the continuation of a “free” exchange rate environment. The current exchange rate, which stands at 1.3510, at the time of writing, is certainly low for Germany which has a positive trade balance but is much too high for all other Eurozone countries, including France. Greece would need parity, Spain & Italy around 1.10, and France perhaps 1.20. Germany has proved it can live with an exchange rate upto 1.40-1.50 although this is a strain.

Angela Merkel

The problem is that Europe is presently curved to Germany’s interests and it is now time for the ECB to show its independence from Frauline Merkel. A rising Euro certainly doesn’t serve the present interests of the Eurozone and will ultimately lead to rising debt costs and more pain. While most analysts expect nothing today from the ECB, we have laid out here our case for a rate cut or at least on some language at the press conference that can make us believe that it is on the cards!