Critical ECB Meeting, SNB Steps Aside

The European Central Bank meeting today is critical. As is its pattern, it holds two meetings a year outside of Frankfurt. Today’s meeting is in Lisbon, which is one of the local governments (five in all) that Moody’s put on credit-watch yesterday for a possible downgrade alongside the sovereign. To be sure, what is at stake here is not so much a change in rates. ECB President Trichet’s prepared remarks and the following press conference is where the real interest lies. The market is looking for the ECB to take some additional measures to address the crisis.

Two potential courses of action seem highly unlikely and can be ruled out. There has been talk that the ECB could buy sovereign bonds outright. This is a non-starter for now and the foreseeable future. There is already a backlash from previous climb downs from the ECB, including willingness to accept Greek bonds as collateral regardless of their creditworthiness. ECB member and BBK President Weber appeared to close the door on the issue when he was quoted yesterday saying that the Greek crisis does not necessitate “using every means.” In addition, recall that the ECB charter bans it from buying sovereign bonds directly, though apparently and theoretically could do so in the secondary market.

The second potential course that is ruled out is that Greece is asked to leave the union. This is also a non-starter. If some think that having the IMF participate in the financial support facility for Greece was a loss of face, Greece leaving would be an even greater admission of failure. Moreover, it does not really solve very much. Greece would still owe (mostly European banks) more than hundred billion euros. The idea of Greece being able to reintroduce a currency with the sole purpose of debasing it seems unrealistic and a dangerous experiment.

There are a couple of more compelling options for the ECB. The first requires taking our eyes off Greece for a second and looking at the funding stresses that are evident in European money markets. Short dated Euribor rates have moved above the German 2-year yield, for example. The spread now is around 20-25 bp. During late 2008, the spread widened to around 80 bp and the ECB responded by injecting massive liquidity into the banking system. It will be disappointing to the market if the ECB does not address this liquidity issue in some fashion today. It could renew its facility to provide unlimited cash for a longer period of time, say three months, and could revert back to fixed rates repos. Some US money market rates also reflect some distortion as European financial institutions scramble to secure dollar funding. This could prompt the ECB to explore renewing the dollar swap lines with the Federal Reserve.

A successful press conference today could see the euro stabilize, which could encourage some of the momentum traders to move to the sidelines. However, over the medium-to-longer terms, the path of least resistance remains a weaker euro. If the austerity in the Meds is effective, weaker domestic aggregate demand can be blunted on the margins with increased foreign demand—and in export-oriented Europe this means a weaker euro. And of course, if the EU/IMF program is not successful and contagion is not arrested, surely further declines in the euro are likely.

Money leaving the euro zone appears to have sought safe harbor in Switzerland. There has been relentless pressure on the euro-franc cross, but one would not notice it looking at a chart of the price action. The Swiss National Bank is believed to have provided several billions of francs this week to meet the dramatic demand. At some point, though, we thought there were limits to the SNB’s willingness to fight the market. That point appears to have been reached today.

Perhaps the data provided the spur. Switzerland reported a dramatic 0.9% rise in April’s CPI. The year-over-year rate remained steady at 1.4% due to base effects. Frankly, a good part of the month’s rise appears to be a function of the seasonal increase in clothes and shoes (+17.6%). It is true that last month the SNB increased this year’s inflation forecast to 0.7% from 0.5%. However, it seems on balance that the SNB used the cover of today’s report to alter tactics. Don’t be surprised to see them re-enter at lower euro/higher franc levels.