ECB Day and other Developments

The focus is squarely on today's ECB meeting. The euro, Swiss franc and sterling are consolidating the gains that have carried them to multi-week highs against the dollar. Expectations are running high that the ECB delivers a 25 bp rate cut today. 

While we have anticipated a rate cut here in Q2, we think there is substantial risk for disappointment today. Of course, the economic justification for a cut in the refi rate exists, though it has arguably existed for several months. Recall that at a meeting earlier this year, many, if not most on the ECB favored a cut, but to seek a consensus, it was not enacted.

There has been no marked deterioration in most of the economic data since the last time the ECB met. The next set of forecasts are due next month and a case can be made that a change in the forecasts should proceed a change in policy. However, the main two reasons why the ECB may prefer to wait for June are:

1) There has been a clear push away from the kind of fiscal and structural reforms the ECB has long advocated. Tighter fiscal policy encouraged extremely accommodative monetary policy (low rates, full allocation, liberal collateral regime). The ECB's views dictate that the initial response to easier fiscal policies should not be easier monetary policy.

2) The conventional view is that the problem with the transmission mechanism of monetary policy is with the credit to small and medium sized businesses. This is really the focus of the ECB, judging from the number of different officials have cited concerns. Yet the ECB does not seem ready quite yet to unveil a new initiative. The results of the UK's Funding for Lending Scheme is not very inspiring. There has been talk of an adjustment of collateral, where technical adjustments look likely if loans to small and medium sized businesses are really to be used.

Since it is the deposit rate (set at zero) that is the key to short-term euro area rates, a 25 bp cut in the refi rate would be largely symbolic, after initial choppiness, the market is likely to take its cues from Draghi's press conference. We suspect a shift in tone and assessment. The outlook for inflation does not seem as balanced and there continues to be downside risks on the economy, especially with the recent string of poor German reports.

The EMU final manufacturing PMI was marked up to 46.7 from the 46.5 flash reading from 46.8 in March, which would seem to suggest a preliminary sign of stabilization, especially as the new orders component rose to 45.4 from 44.9 in the flash and 45.3 in March. This is a forward looking indicator, while the current output reading fell to 4 month lows.

The euro has rallied as the market expectations of an ECB rate cut increased. Although it may be counter-intuitive, we suspect disappointment with the ECB could led to a move lower in the euro, constrained, as it were by the proximity of the market-sensitive US jobs report tomorrow.

The Financial Times headline story is that the Fed shifted policy yesterday by indicating flexibility in the pace of its purchases. We beg to differ. Bernanke and other Fed officials have already made this point. Therefore, we would file in "policy clarification" folder not "policy shift" folder.   

That said, we have recognized that if the economy continues to slow sharply, while the core PCE deflator trends lower, the terms of the debate will shift from tapering off to accelerating the purchases.  The FOMC statement about the pace of purchases was neutral and phrased in a way to achieve consensus.  The Federal Reserve paid little note to the recent economic softening, though did acknowledge the lower price pressures.  

Elsewhere, the Australian dollar is the poorest performer today among the major currencies, extending yesterday's loss to nearly 2 cents.  Several factors are weighing on it, leaving aside the poor press it is receiving (WSJ).  The softer reading on HSBC's China PMI (50.4 vs 50.5 flash)) was not helpful nor the weaker commodity prices that resulted.  

Australia's own manufacturing PMI plummeted (36.7 from 44.4) we learned yesterday and today we learned building approvals fell 5.5%, whereas the market had expected a 1% increase.  The March decline more than offsets the 3.0% (initially 3.1%) gain in February.   Rate cut expectations are rising and now looks to have moved above 50% for next week.   A break of $1.02 may trigger another round of stop loss selling. 

China returned from its May Day celebration and markets re-opened for the first time this week.  They sold shares a bit as the Shanghai Composite slipped almost 0.2%, though other indices posted gains.    In Shanghai basic materials dragged the overall index lower with an outsized 1.5% decline.  The yuan itself was fixed higher and a new 19-year high has been recorded.  Although the persistent grind higher is taking many by surprise, it appears purposeful insofar as the PBOC today raised the reference rate by the most since mid-Oct.  There continues to be talk of a wider band, but the width of the band does not really determine the pace of the managed move.