With the threat of a recession hanging over Europe, the action of the European Central Bank (ECB) is likely to be the focus of attention over the next few months, and in particular, analysts will be looking for some signs of a long-term strategy.
Whilst we have seen the US cut interest rates six times this year and the Bank of England take similar action four times, in the run up to the last ECB interest rates meeting at the end of last month we were still waiting for a cut in the European rate.
The ECB has lowered interest rates just once during the year. The reason for this, according to the bank’s chief economist Ottmar Issing, is that current interest rates are keeping inflation in check without curbing growth in the 12-nation single currency zone.
Speaking to an Italian newspaper last month, Issing said, “The short and long-term real interest rates are still quite low and are not putting any brake on growth”. In a reference to Article 105 of the bank’s constitution he went on to emphasise that the bank’s policy making is shaped by worries about inflation. “It is true that prices have fallen and that the downward trend will continue, but inflation is still close to 3%. There is still a long way to go to get it back to a level we consider necessary for stability – 2%.”
This view endorses the bank’s stated position on interest rates: that its constitution dictates that its “primary objective is to maintain price stability” or, put another way, to tackle inflation. Nonetheless, it is also charged with supporting the Euro-zone’s economic policies and promoting growth, and many critics believe that it should be taking a more pro-active role in stimulating growth or heading off recession.
Interestingly, Issing suggested that although the Euro-zone could be affected by the slowdown in the US, the worst could already be over. “Europe’s economy is growing faster than the US, something we have not seen for a long time, so the Euro-zone is in a better position than America.” This view is somewhat at odds with the bank’s own monthly bulletin for August, which suggests that it may have got some of its arithmetic wrong.
A bank spokesman, referring to the monthly bulletin, said that some analysts had predicted rate cuts but without taking into consideration relative rates. “To draw a parallel with the Bank of England, its main rate is at 5% and we are currently below that. It is hardly ever mentioned that our rates are lower, even though we have not embarked on a series of cuts. So far as general policy is concerned we will be looking closely at the money supply figures before making any decisions over the next quarter.”
As some of Europe’s larger economies embark on a slowdown, the deciphering of the bank’s policies is now a matter of urgency, but the very nature of its deliberations makes this difficult. Its adherence to a policy based on money supply figures and other inflation indicators has been criticised recently. Indeed, the process is so complex that the bank had to admit last month that it had misread some of its own data. The fact that no minutes of the interest rate meetings are published makes its intentions hard to predict. Strict adherence to the mandate laid out in Article 105 can make for an inflexible approach, again opening the directors to criticism.
Alain Cauberjhs of Cordius Asset Management in Brussels believes that the ECB will be cut at least once over the next quarter. “Quite when it will happen is not clear. Looking at the economic data available suggests it should be sooner rather than later. For example, the latest figure for economic growth in Italy was really bad, and we believe that the ECB has no option left other than lowering interest rates. Part of the ECB’s philosophy is that sticking to an inflation target of 2% will automatically help growth. In this respect it mimics the old Bundesbank methods of inflation targets.”
Looking across the Euro-zone, Cauberjhs says we are not on the brink of a recession, although there is an economic slowdown. “The ECB believed that Europe would be immune to the downturn in the US, and that was clearly wrong. The Euro-zone is not as isolated as many people think, and it is clearly affected by what happens in other jurisdictions, and the bank has underestimated the impact. At the moment the consumers in Europe are still spending, and if that driving force remains in place we should not fall into recession.”
Gerhard Winzer, senior analyst at Bank Austria in Vienna sees the ECB set to respond aggressively to the perceived slowdown. “In the money market curve, 75 basis points are already priced in, indicating a 3.75 key interest rate. We believe the ECB will cut interest rates by 25 basis points very soon, and then opt for another similar cut over the next two quarters, leaving a key rate of 4%. The general assumption is also that the US economy will accelerate over the next six months. Should that not be the case, and we see a depreciation of the dollar, then expect the bank to cut by much more than what is already priced in.”
So what does all this mean for the bond market? Winzer says he currently sees a bullish trend in the short-term towards lower yields. “The trend is for the 10-year euro reference yield target to be 4.7% in the short term. The main driving factors are weak economic figures and decelerating inflation rates. The whole of the third quarter will see weak economic figures forcing lower yields across the Euro-zone. In the medium term we will see higher yields than today. In six to nine months no-one should be talking about recession and we should be seeing recovering US and European economies. So short term we are bullish but medium term slightly bearish. On the 12 month horizon we forecast the 10 year reference yield to be 5.30%.”
The influence of the telcoms sector remains significant, however, funding as it does the enormous borrowing taken on by companies bidding for licences for the new generation of telephones and the remainder of the wireless business. Similarly the auto sector has seen credit deterioration forcing some borrowers to replace short-term borrowing with long-term funding. The euro-denominated high yield market also came under pressure from ailing telecom credits.