Release: ECB Interest Rate Decision (3rd Quarter)
Consensus Forecast: -0.25% to 1.0%
Current Rate: 1.25%
Date/Time: 12/8/11 at 7:45AM ET (12:45 GMT, 12/7/11)

ECB to Cut Rates in Back-to-Back Meetings? Likely.

The EU Summit will come amid the ECB meeting in which expectations are rising that the Governing Council will cut interest rates by another 25 basis points to 1% from 1.25%.

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The recent macro data has shown the euro-zone sliding into a mild recession, though a pick-up in recent German data has lifted spirits a bit that the largest economy in the Euro-zone is weathering the storm - so far. Still with spreading concerns about funding pressures for the European banking sector, the ECB sees significant downside risks.

Jürgen Stark that chief economist on the Governing Council has said that inflation is set to decline below 2% next year and that that there is increased uncertainty and higher prospects for recession.

From Nasdaq: The ECB projects that euro-zone inflation will fall below 2%, its medium-term target, in the course of next year as the economic outlook has worsened and it's reasonable to expect moderate price, cost and wage pressure amid the intensified downside risks, Stark said.

ECB President Draghi, echoed those concerns about the prospect of inflation undershooting the bank's mandate of price stability - the dreaded concern over deflation.

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This comes despite inflation currently running at a pesky and high 3%.

From Reuters: The ECB's monetary policy is constantly guided by the goal of maintaining price stability in the euro area over the medium term - and this applies to price stability in both directions, Draghi told the European Parliament.

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For those who were present, Draghi delivered a sobering message on the economic outlook: We have observed serious credit tightening in the most recent period, which combined with the weakening of the business cycle, doesn't bode at all well for the months to come, he said.

Those assessments from the ECB President and Chief Economist means the ECB is likely to follow up its November rate cut with another 25 basis point cut in its Thursday decision.

The question is whether there is a chance we see a 50 basis point cut - a move that is being discussed but likely not priced into the market. That would put the ECB interest rate at a record low, and certainly create weakness for the EUR from a fundamental (interest rate yield) advantage.

3 Main Scenarios for the Rate Decision:

Let's do a quick rundown of this scenarios for that ECB decision.

Scenario #1: No Rate Cut, Rate Remain at 1.25%: if the central bank holds rates steady it would catch the market perhaps leaning in the wrong direction as action by the central bank is now widely expected. This would support the euro from a fundamental interest-rate yield perspective, but may pressure European risk assets as it means that the ECB does not see current economic data falling enough to warrant a move following it's November rate cut. pending on the other options the ECB can take, which are described further below, the bank may still provide a strong sense of monetary stimulus even without an interest rate cut. Therefore the determining factor will be the Outlook expectations of the ECB to inflation. Recent commentary from the ECB officials seems to suggest that weaker inflation is the bigger concern currently. Therefore this is a lower possibility scenario, and would be the most euro positive from the currency's yield perspective out of the three options.

Scenario #2: 25 BP Cut to 1%: the 25 basis point cut by the ECB would show that the recent data showing weaker growth and weaker expectations for inflation is enough for the ECB to lower borrowing costs for second straight month. This would leave the door open to further easing in the first quarter of 2012, and the ECB would have a further chance to see where inflation heads in the coming month(s). combined with other measures to ease the cost of borrowing for the European banking sector, the ECB likely will judge a quarter-point cut to be sufficient as it continues to monitor the situation.

Scenario #3: 50 BP Cut to 0.75%: This scenario implies that the ECB sees serious downside risks and that there euro zone may be headed for a stronger than expected recession as well banking funding issues will pressure lending and credit growth. this move would be stimulative for risk assets which should benefit from such a strong response on the central bank. However from a interest-rate yield perspectivethe euro would be much weaker and therefore such a decision would likely cause the euro to fall in response. On the other hand other riskier, higher-yielding currencies that move with risk sentiment like the commodity bloc - AUD, NZD and CAD - could benefit from such a move. By cutting 50 basis points to 0.75% the ECB would be putting interest rates at a record low.

Other Easing Measures by the ECB Expected:

The ECB is preparing to take further steps in order to help ease the strains on the European banking sector and prevent a banking crisis. We have written about the measures that the ECB would need to introduce in order to help facilitate an easing of the pressure on the European banking sector.

In addition to lowering interest rates, t
he ECB can offer loans to banks at longer maturities than the current maximum 13-month loans the ECB will be offering this month. Reporting has said the ECB is considering 2 to 3 year loans becoming available. In essence that is a form of quantitative easing by the ECB - though not directly buying government bonds it is still putting money in the banks and helping cause credit creation.

The ECB may also decide to ease its requirements for collateral in order to lend European banks, which can also help give banks further access to ECB liquidity.

From Bloomberg: The ECB is focusing on getting banks lending again rather than increasing its government bond purchases to fight Europe's debt crisis. The central bank's insistence that governments take measures to restore investor confidence appears to have paid dividends, with Italian and Spanish yields plunging after Germany and France agreed to move the 17-nation euro area toward a fiscal union, a stance they reiterated today.

width=431The ECB's role tomorrow is going to be pretty much about the banks, and after tomorrow the liquidity side should be on a much stronger footing, said Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc in London. The division of labor is very clear - the ECB takes care of the banks, and the sovereigns take care of the fiscal side.

This is an interesting division of labor here, and holds closer to the role the ECB is comfortable playing - taking care of the banking system and inflation. The clamor for buying more sovereign debt bonds should be dealt with by politicians and we'll see their response to calls for further action as we proceed through the Summit.

European Banks Already Using the ECB Recent Liquidity Tools:

With funding pressure at the core of recent European bank woes, and the action by the Fed and other central banks last week to help ease he's the cost of borrowing for European banks, a further move by the ECB to lower interest rates would also accomplish a similar objective.

As we discussed in an earlier post on Euro-zone developments the ECB saw a very big uptake in its 3-month dollar loans, after the Fed's move last week. 34 banks borrowed $50.685 billion at the ECB's 84-day dollar swap, a month after only 2 banks used the facility and borrowed around $0.3 billion.

There's 2 ways to read into this. One, its good for easing the funding pressures for European banks that they are taking advantage of the extra liquidity and this shows that the move by the Fed and other central banks is so-far successful. On the other hand, the fact that so many banks needed to take on these 3-month loans means that the other options for banks in raising funding is limited, a sign of the stress on the system.


Nick Nasad is the Chief Market Analyst at FXTimes - provider of Forex News, AnalysisEducationVideosCharts, and other trading resources.