Euro zone rate cut prospects evaporate

August 27, 2013

The euro zone is growing again and while its weaker constituents face plenty of tough times yet, it seems less and less likely that the European Central Bank will cut interest rates from their record low 0.5 percent. That illustrates the problems of the new fad of forward guidance.

The ECB deliberately stayed vaguer than most – a product of ripping up its custom of “never precommitting” – saying that rates would stay at record lows or even go lower over an extended period.
Its monthly policy meeting falls next week and in a parallel transparent world Mario Draghi could consign the “or lower” part of the guidance to history after just two months. Don’t bet on that happening but it shows how quickly things can move.

If anyone in Europe, Britain or elsewhere is hoping for a cast iron guarantee that rates won’t rise for two, three or more years, forget it.
Exhibit A today will be Germany’s Ifo sentiment index which has been coming in strong in recent months and is not expected to buck that trend.
It must be only a matter of time before the government and Bundesbank upwardly adjust their forecasts for a significant slowdown in the second half of the year, following 0.7 percent growth in the second quarter.

The ECB will publish its latest economic forecasts for the euro zone next week. ECB policymakers Jens Weidmann, Benoit Coeure and Joerg Asmussen are all speaking during the day. Last week, their colleague Ewald Nowotny broke ranks saying he saw no good arguments for a rate cut now.

Italy will sell up to four billion euros of zero coupon and inflation-linked bonds while Spain will offer four billion euros of treasury bills.

Madrid is positioning itself favourably to Rome – which may be about to plunge into a fresh political crisis – by trimming its monthly bond issuance by a third from here to the end of the year, having already shifted three-quarters of its 2013 funding needs. Italy is also ahead of the game but will carry on issuing as before, presumably pre-funding some of its 2014 requirements.
That might prove prudent in the long run but in the short term, Spanish borrowing costs will outperform – the 10-year spread over Italy hit an 18-month low of just 8 basis points on Monday – and the Italian political backdrop will exacerbate the situation. The bigger test comes with a 5- and 10-year Italian bond auction on Thursday.

Members of Silvio Berlusconi’s centre-right party are threatening to bring down the government and trigger early elections if their centre-left coalition allies vote next month to expel the former prime minister from parliament, following the upholding of his conviction for tax fraud. If he is not barred, swathes of Prime Minister Enrico Letta’s centre-left would react with horror.
None of that means the government is fated to collapse but it is a live risk and if it happens at the same time as the Federal Reserve starts scaling back its money-printing – which would probably push up euro zone peripheral bond yields anyway – it could get nasty quickly.

Emerging markets are back in turbulent times given the Fed may start “tapering” as soon as next month. That has not stopped Hungary’s central bank, chock full of government appointees, cutting rates month in and month out. But after 10 successive quarter-point cuts took rates to 4.5 percent, analysts expect a smaller 10 basis point easing today.

The forint hasn’t suffered the hammering meted out to other emerging currencies – in fact central and eastern European assets have proved to be something of a safe haven — but that might not last forever.
No such luck for Turkey where the lira has weakened through 2 per dollar for the first time after the United States signalled possible military intervention in Syria. The central bank is under pressure to take more dramatic action to steady the currency.

South Africa’s rand hit a four-year low against the dollar last week and is down 22 percent on the year, putting second quarter GDP figures and a speech by Finance Minister Pravin Gordhan sharply into focus.

Annualised quarterly growth of 3.3 percent is forecast, healthy enough on the face of it, but Gordhan told us in an interview last week that he was wary about a jump in inflation given the rapid currency depreciation and South Africa is facing strikes across leading sectors, with the auto manufacturers taking industrial action and construction workers and airport workers going on strike on Monday. Gold miners are threatening to follow suit.

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