Draghi Turns Spigots, but Still a Drag

The ECB has giveth and taketh away today, leaving the market pessimistic about the outcome of tomorrow's summit.

The ECB delivered the much expected 25 bp rate cut, though the decision was not unanimous. There was some immediate disappointment by some players positioned for the outside chance of a 50 bp move. The ECB addressed the liquidity and collateral measures to address the credit crunch. The ECB will provide two 3-year refi operation, which will replace the previous long-term repo operations (LTRO). Participating banks will have the option to return the funds after one year.

 

The collateral rules have also been relaxed, with some ABS and bank loans acceptable. The ECB also reduced reserve requirements. Broadly speaking, taken en toto, the liquidity provisions and collateral rules are at the more aggressive side of expectations, though the rate cut itself was in line with expectations.

Yet at the same time, ECB President Draghi threw cold water on two ideas that warn that the summit that begins tomorrow will not lead to ECB increased bond purchases or resolve the role of the IMF in future support efforts.

Draghi was very clear that the bond purchases were temporary in nature, not aimed at defending a particular rate (say like 7% in Italy's 10-year yield), but was to help the transmission mechanism of monetary policy. Moreover, Draghi was explicit that he felt his recent comments were misunderstood. Some in the media had suggested he was opening the door to grand bargain, offering some thought a version of QE in exchange for a new fiscal agreement.

Secondly, Draghi seemed to play down the likelihood that the role of the IMF will be sorted out quickly, ie this weekend. Draghi noted that the situation is complex and that the ECB itself was not a member of the IMF. Recall that European officials had begun exploring the idea of the ECB (and Fed ?) lending money to the IMF that in turn would lend to the troubled peripheral countries.

As we had anticipated, the positive knee jerk reaction in the foreign exchange market was quickly unwound and the euro (and other highly correlated risk currencies) have been sold off to new session lows. The euro fell to its lowest level in 6 days, finding support just ahead of $1.3300. We suspect that choppy trading may continue but most participants have the pre-summit positions set.

There does not seem to be a set timetable for the summit and it would not be surprising if the brinkmanship of the summit carries not just into Saturday but Sunday as well.

Further out, we do not think the ECB is done cutting interest rates. The 1% floor was reached previously but there is nothing cast in stone there. The ECB sees the risk to growth significant to the down side, while risks to inflation were regarded as balanced.

The ECB staff offered new forecasts. This year's growth is now seen in the 1.5%-1.7% area vs 1.4%-1.8% estimate in Sept. This seems to largely reflect the recent data rather than a real new forecast. However the 2012 forecast has been seriously cut. Rather than 0.4%-2.0% growth anticipated in Sept, the ECB staff now sees growth between -0.4% and +1.0%. This is sobering: the prospect of a more prolonged downturn that leads to negative growth for the entire year and the risks are on the down side.

Inflation is expected to be a bit stickier. For policy forward looking inflation is of course more important than contemporaneous readings. The said, this year's inflation was revised to 2.6%-2.8% from 2.5%-2.7%. Next year's inflation forecast was revised to 1.5%-2.5% from 1.2%-2.2%.

Lastly, Draghi explained that regarding the sterilization of the ECB bond purchases, that technical glitches may impact from time to time, but this is not QE and will be managed. Draghi also indicated that the ECB will act on behalf of the EFSF if and when it operates in the markets to buy sovereign bonds.