We had several key developments in the euro zone today which created some back-and-forth conditions in the euro dollar and some big back-and-forth swings against other crosses such as the Australian and New Zealand dollars.
ECB Rate Cut, Threat of Growth Highlighted
Perhaps the most important fundamental development today was the fact that the ECB lowered its interest rates from 1.5% to 1.25%, a reduction of 25 basis points. It was the first central bank meeting chaired by incoming president Maria Draghi and reversed half of the rate increases by the ECB seen earlier in the year (in April and July).
The ECB believe that inflation would fall below its 2% mandates and that the macro situation was pointing to a mild recession in Europe.
From the Statement: While inflation has remained elevated and is likely to stay above 2% for some months to come, inflation rates are expected to decline further in the course of 2012 to below 2%. A cross-check with the information from our monetary analysis confirms that the underlying pace of monetary expansion continues to be moderate. After today's decision, inflation should remain in line with price stability over the policy-relevant horizon. Owing to their unfavourable effects on financing conditions and confidence, the ongoing tensions in financial markets are likely to dampen the pace of economic growth in the euro area in the second half of this year and beyond. The economic outlook continues to be subject to particularly high uncertainty and intensified downside risks. Some of these risks have been materialising, which makes a significant downward revision to forecasts and projections for average real GDP growth in 2012 very likely. In such an environment, price, cost and wage pressures in the euro area should also moderate; today's decision takes this into account.
I had written about the weakening macro picture in Europe in our preview of the ECB and today's announcement by the ECB that they will be revising down their forecasts and don't see inflation as a threat is an important fundamental factor to consider as we move through the next few weeks with the Euro.
He expected real growth rates in the second half of the year to be very moderate and were very likely to be downgraded when the ECB releases new staff forecasts next month.
In the most basic terms lower interest rate narrows the interest-rate yield advantage the Euro enjoys against its lower yielding rivals - like the pound, US dollar, Canadian dollar, Japanese Yen, and Swiss Franc - and widens the interest-rate differential between the euro against higher yielding currencies like the Australian and New Zealand dollars. We saw that today as the EUR fell against the Aussie, Kiwi, and Canadian Dollar, though it managed to stage a strong correction.
At the same time, lower borrowing costs should work to support the economy as it makes borrowing cheaper for households, companies, and governments. The bank did not offer hints of further interest-rate cuts and so we'll have to watch the macro data to gauge whether we get another interest rate cut in the next three months.
ECB Loosens Up its Covered Bond Buying Program
While it was not mentioned at the press conference the European central bank also launched its second covered bond buying program - a non-standard measure that had been used before to support the banking sector.
From Businessweek: The European Central Bank is relaxing the terms on its new 40 billion-euro ($55 billion) covered bond purchase program by accepting lower-rated securities than under a similar plan in 2009. The ECB will buy covered bonds with the lowest investment- grade ratings under the new program, according to a statement in the Frankfurt-based bank's web site today. That's five steps below the minimum grade the ECB required two years ago under its 60 billion-euro program to purchase the loan-backed debt.
The ECB's covered bond purchase plan is part of its efforts to improve banks' access to market funding and spur lending. Covered bond yields soared 45 basis points this year to 172 basis points more than the swap rate, according to Bank of America Merrill Lynch's EMU Covered Bonds index, amid concern banks' will need to write down investments in peripheral euro- region countries.
Covered bonds are similar to mortgage-backed securities, and by buying them the ECB would be taking assets off the books of banks giving them theoretically more money to lend.
This is a stimulative measure, though the ECB tends to sterilize its purchases (drain the same amount via other monetary tols) and so it's not the same as quantitative easing - in which the Federal Reserve increases its balance sheet for instance. It's certainly apparent that the ECB is trying to step up its role in helping abate the downdraft in the economy.
Greece Scraps Referendum, Market Applauds as Threat of Greek Default Abates.. For Now.
While the ECB decisions on rates and its covered bond buying program - will likely have the biggest impact going forward from a fundamental perspective, the big news today was the riveting back-and-forth developments in Athens. First there were rumors that George Papandreou might resign, but those rumors were quickly beaten back. Then after meeting with the Cabinet and opposition parties, the Prime Minister called off the referendum as the opposition agreed to vote for the austerity measures imposed by last week's European Summit.
From FT: Over in Athens, the narrative of today's developments is becoming clearer. According to the prime minister's comments to his cabinet, the key turning point appears to have been when Antonis Samaras, the conservative opposition leader, said today that he would be willing to back the new bail-out agreement in order to ensure Greece stays in the euro. The conservatives opposed Greece's previous bail-out on the grounds that harsh austerity would deepen the country's recession and leave banks without liquidity to fund investment. Kerin Hope has more from the text of Papandreou's address to minister at their emergency meeting earlier:
There is no need for a referendum following the conservative opposition's switch of its position and willingness to back the October 26 package.
We must hail the fact that [the main opposition party] New Democracy will vote for the new bail-out agreement.
We had a dilemma: consensus or a referendum ... Failure to back the package would mean the beginning of our departure from the euro. But if we have consensus, then we don't need a referendum.
The threat of a no vote or the consequences of calling early elections would have very dangerous ramifications. With the opposition relenting and agreeing to back the austerity measures , the country can move on with a sense of consensus, that is if the people of Greece expect to stay in the Euro and the EU.
With the referendum scrapped, that takes away the uncertainty of a no referendum creating a disorderly default in Greece, or the prospect of EU and IMF holding back the next tranche of aid for Greece, which could also result in missed payments by Greece of its debt.
With the support from the ECB - in the form of both cutting interest rates and and covered bond buying program - as well as the scrapping of the referendum by Greece, it created positive momentum for the euro today generally, as the EUR was able to pare back its initial losses following the surprise ECB rate cut.
Monitoring G-20 Developments:
The attention now will turn to the meetings and headlines that we get out of the G20 to end the week.
Part of Europe's plan is to get support from foreign lenders to help retool the EFSF and help leverage its assets. The idea has been floated that sovereign wealth funds, private investors, countries like China and other BRICS, or the IMF can put up funds that can be used to help create a firewall for Italy and Spain.
How supportive will the US, China and others be to fork over their citizens money to help the Europeans? Well, it generally in the interest of everyone that the sovereign debt crisis is contained and that it does not further seep into the real global economy . Still, it requires governments to explain why they are spending money on helping Europe and Greece's government and banking sector to their constituents.
Still, some ideas are being floated around.
From Marketwatch: Some countries fear Europe's efforts won't pack enough punch. So one alternative is for the G-20 to consider supporting another allocation similar to the $250 billion one the G-20 approved in 2009. Other countries, such as the U.S., oppose using more resources through the IMF. Washington, which has veto power over such a move, believes Europe has enough resources to stem the crisis and wants to keep pressure on the euro zone to solve its own crisis. The U.S. is also concerned that emerging market countries may try to use boosting resources available through the IMF to leverage more power at the IMF.
Specifically, they want to increase the amount of reserves countries hold at the IMF called an SDR allocation. A Special Drawing Right is the unit the IMF uses that represents a selection of key global currencies.
Here's another take on this SDR's and what the G20 may be thinking.
From Reuters: The G20 is considering a proposal by the International Monetary Fund to create a new short-term line of credit to help countries that are facing economic shocks beyond their control, a G20 official familiar with the talks said on Thursday.
In an another effort to boost liquidity, the G20 is also considering injecting billions of dollars into the global economy through a second special allocation of IMF Special Drawing Rights (SDRs). Such a move would bolster financial stability in the face of growing uncertainty caused by the euro zone sovereign debt crisis , the official said.
The new credit facility would be built into the IMF's existing Precautionary Credit Line for well performing countries encountering balance of payment needs caused by exogenous shocks. The official said IMF member countries would have to request the credit line, which would be made available over a period of six months without IMF conditionality. The amount of financing would be capped at about 500 percent of each members' IMF quota, or subscription.
Wrapping Up A Busy Day
Equities responded positively to the news out of Greece as well as the fact that the ECB has stepped up to help the ailing euro zone economy. Depending on how events at the G20 go as well, as the very important non-farm payroll report due out tomorrow, that should set the tone for risk sentiment as we start next week.