ECB Decision Day

In the social world, sometimes the cause takes place after the effect. This appears to be the case in the foreign exchange market. The effect has been the euro's four cent decline since the last ECB meeting. The cause will be delivered today.

ECB officials often say they do not pre-commit. They have come the closest to that now, as the failure to act would trigger punishing activity, not only for investors but for policy makers. No, the market participants understand that there will be action today and most likely in the form of rate cuts, including a strong likelihood that a negative deposit rate is introduced. The ECB may also announce a funding-for-lending scheme that would be more favorable for peripheral countries than the core.

Similarly, at the first level of analysis, a negative deposit rate would impact the banks that use the facility at the ECB. These are banks from core countries with surpluses.   Since the deposit rate was cut to zero in mid-2012, creditor banks have shifted funds away from the deposit facility and to the current account facility, which also pays no interest but allows greater flexibility. Many observers see the decline in the use of the deposit facility and look at the Danish experience and see little secondary impact from a negative deposit rate.

Denmark, you will recall, adopted a negative deposit rate in July 2012, where is remained until recently (April). The Danish krone weakened slightly against the euro (~0.5%), and the negative rate was not passed on to retail. It did not spur bank lending. For a large central bank, like the ECB, a negative deposit rate is still an experiment. We see potential for greater disruption and dislocation for large depositors, which include governments, corporations and investors. We are concerned about the impact on money markets. There is risk that a negative interest rate imparts a contractionary impulse.

At his press conference, Draghi is likely to impress upon the market that the ECB is prepared to do more if necessary. That "more" is a reference to asset purchases, for which there remains technical and legal difficulties, let alone a consensus. Some of the technical issues involve the changing the capital requirements of asset-backed securities and registering securities, for example. There would be a conflict of interest for the ECB to buy bank bonds, for example, before the Asset Quality Review and the stress tests are completed.

Barring a significant surprise from the ECB, we suspect the knee-jerk reaction will be to sell the euro., but that the pullback is likely to be limited and seen as a new opportunity to buy the euro and European assets. We argue that underlying causes of the euro's resilience are tied to two factors the ECB will not be addressing: 1) the large current account surplus and 2) the strong interest in European bonds, stocks and direct investment, especially in the context of the continued deleveraging of the banking sector.

There are a few other developments to note, but the ECB meeting overshadows everything else. First, the Bank of England also meets today. The minutes will be released on June 18 and insight into the meeting will have to wait for then. The decision to leave rates on hold will be unanimous, but increasingly the debate about spare capacity and rate hike strategy will come to the fore, leading to the risk of dissent later in the year. Separately, we note that another housing price index showed rising prices. Earlier this week it was Nationwide. Today it is Halifax, which reported a 3.9% increase in May for an 8.7% year-over-year increase.

Second, after some disappointing survey data, German reported strong factory orders, which points to upside risks on tomorrow's industrial output report. Factory orders jumped 3.1% in April, recouping in full the 2.8% decline in March This is more than twice what the consensus expected. German companies are competing well with a strong euro. Export orders were up 5.5% on the month, while domestic orders were flat. Consumer goods orders were the strongest (7.1%), followed by capital goods orders (4.4%).

Tomorrow the Bundesbank will update its economic forecasts. In its December forecasts, the BBK expected 1.7% growth this year to be followed by 2% next year. Inflation was forecast averaging 1.3% this year and 1.5% in 2015.

Third, the Australian dollar remains resilient in the face of the unexpected trade deficit reported earlier. The Australian dollar is near yesterday's highs just below $0.9300. A move $0.9330 would likely force some of the recent shorts to the sidelines. The idea may be that if the ECB is going to cut rates, then the quest for yield will be intensified, and the Aussie will be a beneficiary. Australia's Q1 GDP reported yesterday (1.1%) was bolstered almost exclusively by the net export function. Today's news illustrates why it is not sustainable. Australia reported an A$122 mln trade deficit compared with market expectations for a A$510 mln surplus. Exports were off 1% while imports rose 2%.

US economic data pales in comparison to the ECB meeting. The weekly jobs claims are overshadowed by tomorrow's national report. The Flow of Funds report is likely to show a new record high of household net worth, but also more evidence that the deleveraging phase ended as most categories or debt likely increased. Although the ADP data disappointed and the trade figures prompted some downward revisions to Q2 GDP forecasts, growth is still expected to be around 3%.

Canada's IVEY PMI is expected to have risen from 54.1 to 56.0. However, the report is likely to be lost in the reaction to the ECB's move. Tomorrow Canada reports May employment figures, which are expected to rebound after the loss of almost 31k full time positions in April. The US dollar faces immediate resistance near CAD1.0960 and then CAD1.10. Support is pegged around CAD1.0910.