ECB Appears Focusing on Liquidity Measures

There has been some speculation in the markets over the past week or so that the ECB may begin reversing the April and July rate hikes as early as next month. The October 6 ECB meeting is Trichet's last before Draghi takes the reins.

Pricing from the OIS market suggest EONIA rates will remain low and this is achievable through either a ECB rate cut or continued safe haven inflows into the short-end in Europe. ECB member Mersh called the speculation over a 50 bp cut "wild", according to news accounts. However, given the dismal flash PMI readings and its correlation with GDP, the market is aware that the ECB can indeed cut rates next week, even though Trichet did not use the "normal" word cues to suggest it.

On one hand, the ECB's critics argue that is bond purchases are blurring the distinction between monetary and fiscal policy. On the other hand, the ECB draws a line between liquidity provisions and monetary policy (interest rates). At the Sept ECB meeting Trichet said monetary policy was still accommodative. This means that the current refi setting (1.5%) is not restraining growth.

That confirms what European contacts report: that the focus is on liquidity measures. There is talk of re-introducing 12-month (or even longer) refi operations. The ECB last offered 12-month money at the end of 2009.

There is also talk that the ECB can resume its covered bond purchases. Recall that covered bonds are asset backed instruments (usually backed by mortgage or public sector loans) in which the banks retain ownership of the collateral. The covered bond market estimated value is near 2.5 trillion euros. The ECB purchased 60 bln euros of covered bonds in a 12-month program that ended June 2010.

As financial markets and banks became more stressed, the spreads in the covered bond market has risen. Buying covered bonds would be a way to help ease the strain in the market and provide banks another source of liquidity.

In terms of the controversial sovereign bond purchases, the ECB appears to be slowing down considerably. In the most recent week, the ECB settled 3.95 bln euros in sovereign bond purchases, down from 9.8 bln the prior week. It is the least amount the ECB has purchased since sovereign bond purchases in early Aug. Over the past seven weeks, the ECB has bought almost 85 bln euros of sovereign bonds.

The idea that the ECB may be pulling back has reversed the euro gains scored in response to reports that it was considering resuming covered bond purchases. Initial support is seen near $1.3440 and then $1.3400.