One Man’s Opinion: Will The ECB’s Surprise Interest Rate Cuts Be Followed By QE?

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92835431European Central Bank President Mario Draghi surprised markets by announcing cuts in all the three main interest rates after inflation weakened further to a 0.3 percent annual rate in the euro area.

A full-fledged quantitative easing might be unveiled after starting off with asset-backed securities – what Draghi calls “simple transparent ones,” said Kit Juckes, Global Strategist at Societe Generale. The initial purchases are likely to be mortgage-backed debt, commercial mortgage-backed debt, credit card debt and so on.

That’s the first step that gets the eurozone economy up and running. In the next few months Draghi may try to persuade Bundesbank chief Jens Weidman and others to allow him to expand the QE in the general direction of European government bonds too to get at the meat where there is much, much more debt that he can buy into. However, Draghi has made it clear that the ECB won’t be buying complicated debt such as the junior structures of CDO and CDO squared of asset-backed securities, he noted.

The ECB has been traditionally very slow at decision-making because it’s very difficult for the central bank to reach a consensus, said Jens Nordvig, Global Head of Currency Strategy at Nomura.

What was important in Thursday’s meeting was that back in June, when the ECB announced negative deposit rates for the first time, the central bank said it would wait and see for a while before making the next move. However, they initiated the second round of rate cuts within the next three months, indicating it’s getting more and more active. That’s the reason why the market was reacting in a manner that it did, Jens argued.

The latest steps toward recovery are in the right direction even as the ECB is yet to announce either the magnitude or the mix of asset purchases, said Vadim Zlotnikov, Chief Market Strategist at AllianceBernstein. However, If Draghi expands the ECB’s balance-sheet to 3 trillion euros; it will probably be not enough. Draghi’s observation that structural and fiscal reforms were also necessary for the central bank’s monetary policy to be effective was also correct, Vadim observed.

Formulating monetary policies were probably easier than reforming economies of 18 different countries in a highly politicized region. Asked to comment on Nomura’s prediction the euro will slip to $1.27 by the end of September, Jens said this week’s ECB meeting was important. Going forward, the FOMC meeting scheduled for Sep 17 may move in the other direction. So September could see a dramatic divergence in policies between the ECB and the Fed, which could push the euro down below the 1.27 level, he noted.

The euro region is witnessing elevated unemployment rates with some countries like Spain logging jobless rates as high as 25 percent. Asked if a weaker currency could boost exports and put people back to work, Kit said EUR/USD at 1.27 is unlikely to help much. Cheaper money and lower interest rates in are unlikely to solve the region’s problems as there is a lack of demand for credit in the euro area. The cost of money is not currency bloc’s problem and the euro needs to be weaker than 1.27 to be more effective.

However, Draghi’s timing in taking the currency down is good because the ECB and the Fed are moving in opposite directions. If Draghi manages to take the euro below $1.20 in the next two years, that would stimulate economic activity much more than all other measures initiated over the past two years. It was difficult for Draghi to weaken the currency until now as the US Fed kept monetary policies loose by holding the Fed Fund Rate near zero and continued buying assets every month, Kit argued.

Asked if Draghi was actually late in announcing fresh measures as many countries in the region were witnessing deflationary trends, Vadim said higher asset prices in many areas inside the bloc indicated investors were factoring in further drop in inflation rates and yields. The situation has been aggravated further by a fall in consumer and business confidence.

Although measures have been announced this week to boost the economy, the final QE package is likely to be bigger than estimated now. The latest measures, however, are likely to have a favorable impact on credit spreads. Nevertheless, the ultimate goal of opening up the credit transmission channels will not be achieved until a full-fledged asset purchase program is formally launched, Vadim noted.

You can watch the video here.

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