Just a week after warning that euro zone banks will probably have to write off another $280 billion in bad loans and toxic assets over the next 18 months, the European Central Bank has ridden to their rescue by pouring more than double that amount into bank coffers at a bargain-basement rate of just 1 percent.

More than a thousand banks rushed to take up the ECB’s limited-time-only offer of unlimited funds for one year at a fixed interest rate, and will receive a total of 442 billion euros, or $613 billion – the most the ECB has ever lent out in a single operation. 

“We are drowning in money,” a trader at one euro-zone bank said. Goldman Sachs estimated the funds equate to 1,300 euros per man, woman and child in the 16-nation region. 

The central bank is hoping banks will lend the funds on to those men, women and children, as well as other banks and businesses, to bring down the cost of money, encourage spending and shake the region out of a persistent recession.  Money market rates have already fallen to record lows as the ECB has slashed its interest rates, but longer-term liquidity is still scant.

The ECB’s efforts will come to nothing if banks sit on the cash instead of lending it on, or fail to spark consumer demand for credit - so the ECB is betting that spend, spend, spend will light the way out of the downturn.

Five things to think about this week:

STALLING RALLY
- The global equity market rally has stalled in June and is threatening to go into reverse. With this week effectively the last full week of the second quarter, the temptation for many funds to book profits on such a lucrative quarter will be high. Any knock on boost to volatility would pose more risks for some of the trades that looked the most attractive in a lower volatility environment, such as cyclical versus defensives plays, emerging markets, and foreign exchange carry trades.

POLICY, SUPPLY RISKS FOR BONDS
- How the U.S. Federal Reserve will respond to the interest rate market gyrations of the past month has been a key market talking point. Questions centre on whether it will expand the size of buybacks, whether there will be any change in the length of time the buyback programme lasts, whether the central bank makes any effort to unwind the rise in bond yields seen in the past months, and whether there will be any talk of an exit strategy. Another risk to the front end will be the Treasury refinancing, which resumes after a week of no supply and will be concentrating on the shorter end.

WHAT COLOUR ARE THE SHOOTS
- This week's data will show both whether the inventory rebuilding that was priced in over recent months is actually materialising and whether there are any other drivers of economic activity out there. The flash PMI in Europe and sentiment indicators will be particularly relevant in deciding on the latter issue, with consumer and income data out from both sides of the Atlantic providing an additional window on how domestic demand is shaping up.

CENTRAL BANK CASH
- There is potential for significant take up at the ECB's first one-year tender this week and some are speculating that the injection of large amounts of money into the market could drive down short end rates sharply. Most recent anecdotal evidence suggests firms are still facing tight credit conditions but confidence in financial stabilisation is a pre-requisite if banks are to lend on. This is leading to speculation of where else the money might be parked in the interest rate or fixed income universe. There are also question marks over whether any of the money might leak outside the euro zone -- and what, if any, are the potential FX implications of such seepage.

EMERGING MARKET RISKS
- Higher volatility spells underperformance in the emerging market universe and has raised questions over the risks in individual countries -- e.g. Turkey's IMF deal; Latvia's political difficulties in winning acceptance for budget cuts; the possibility of the Iranian domestic upheaval gaining market attention; and ructions within the Saudi banking sector. The shifting sentiment suggests potential hurdles for heavy third quarter corporate and government refinancing needs, especially in central and eastern Europe, not least given that the heavy issuance plans of better-rated developed market sovereigns pose crowding out risks.

The European Central Bank’s decision to buy up covered bonds is one in the eye for the Bundesbank’s Axel Weber.

Alongside fellow German Juergen Stark, he had led a campaign urging his colleagues to shun the current craze among central banks of effectively printing money by buying up debt or loans from their holders, banks. Unfortunately for him, they didn’t agree.

But while he may have lost the war, he certainly scored a substantial victory for his country during the battle. Covered bonds – bonds backed by mortgage loans or public debt - originated in Germany and the country’s banks still dominate the market, meaning they are likely to benefit the most.

“He was not one of the winners yesterday, but it’s a nice loss, let’s put it that way,” said UniCredit euro zone economist Aurelio Maccario. “I think in exchange to have the Bundesbank on board, they have chosen to buy covered bonds which are financial assets from the German banking system.”

ECB watchers speculate that Weber is one of the frontrunners to replace Jean-Claude Trichet in the ECB top job when his term expires in 2011.

The defeat over asset purchases is unlikely to have helped his election chances, but in what may turn out to be strange twist of fate, the ECB has revealed Trichet’s last meeting in charge, on October 6, 2011, will be hosted by the Bundesbank in Germany’s capital Berlin.

The European Central Bank has cut interest rates to a record low of 1.5 percent and although it’s expected to cut further to 1 percent by mid-year, this still means benchmark borrowing costs in the euro zone will be higher than the UK, the US, Canada and Switzerland, where official rates are already at 0.5 percent or lower.

But euro zone residents are actually enjoying more favourable credit conditions than the ECB’s “official” rate, the main refinancing rate, would suggest. 

 The Commerzbank branch opposite the ECB’s Frankfurt headquarters is offering mortages at a five-year fixed rate of just over 3.5 percent,  two percentage points cheaper than the average cost just a few months ago.  This is partly because the ECB, in addition to cutting rates, has flooded money markets with liquidity, meaning banks can borrow money amongst themselves more cheaply than the official benchmark rate.

  Economists I’ve spoken to in the last few months have dubbed this a de facto zero interest rate policy, or ZIRP by stealth.

Average overnight interest rates or EONIA, which would normally track the main refi rate, have fallen steadily in the last few months arnd are down to below 0.9 percent, while Euribor three-month market rates are around 1.6 percent.

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Even ECB policymakers such as arch-hawk Axel Weber say that the ECB’s overnight deposit rate, which is set one percentage point lower than the refi rate at 0.5 percent, has taken over the role as the floor for money markets, while the refi rate is acting as a ceiling.

One more 0.50 percentage point rate cut could take this rate down to zero, putting money market rates on a par with those in other regions while still allowing the ECB to keep to the moral high ground and argue that it is keeping up its guard against future asset price bubbles and inflationary pressures.

“If they go to 1 percent for the refi and put the deposit rate at zero, it means we would have an overnight money market rate at 0.2-0.3 percent, which would be for all intents and purposes a zero monetary policy,” Bank of America Merril Lynch economist Gilles Moec said.

The European Central Bank has to cut official interest rates by at least another percentage point to stop the real cost of borrowing for households and firms jumping in the summer as inflation plummets.

That’s the logical conclusion of comments in recent weeks made by ECB policymakers including Italy’s Mario Draghi and Germany’s Axel Weber, who are watching inflation-adjusted borrowing costs closely to gauge the impact of cuts in official interest rates on the real economy.

One key factor in the euro zone’s economic recovery will be the real cost of borrowing, the interest rate paid on credit after adjusting for inflation, or any loss of purchasing power.

Although there is a long academic debate about how to calculate this, several policymakers have done a simple equation of taking annual inflation (1.1 percent in January) away from the current benchmark interest rate (2.0 percent) to arrive at an estimate of the real cost of borrowing of just under 1 percent.

“In the euro area the real short-term rate is now below 1 per cent; if official rates had not been cut, it would have risen considerably because of the fall in inflation,” Draghi said in a speech in Milan on Feb. 21. “The Governing Council is keeping a close watch on the real cost of money.”

The catch to this argument is that euro zone inflation is expected to fall to zero or lower in the middle of the year, which will push real borrowing costs up unless the ECB slashes official rates by an equivalent amount. If it keeps its refi rate at 2.0 percent, the real rate would also be 2 percent — or double the level it is now.

Economists fully expect the ECB to cut rates to 1.0 percent by the middle of the year, given the dismal outlook for growth as well as very low inflation. But they warn that the real rates argument could backfire on the ECB, which is already under fire for not having cut interest rates as aggressively as its peers in other countries, given inflation is expected to rise again in the second half of the year.

“Does that mean they would follow through by raising rates to compensate? That’s why I think they should be very cautious in using this argument,” said Deutsche Bank economist Mark Wall.

Austria’s Ewald Nowotny is a very busy man. Apart from running the Austrian Central Bank and sitting on the board of the European Central Bank, he has given at least 32 interviews since taking office last September, to publications as diverse as Japan’s Nikkei newspaper and Austrian alternative weekly Falter as well as the usual financial papers.

And his fondness to talk at length on ECB rate policy, the euro, emerging Europe, recession, inflation, deflation, growth forecasts and bank rescues has in turn set tongues wagging. He’s even done an internet chat with readers of Austria’s Der Standard.

“Ewald Nowotny is almost omnipresent. Barely a day goes by without (him) popping up in one of Austria’s publications airing statements about the current economic situation,” German
financial daily Handelsblatt wrote in a recent article, which only appears in its paper version.

There are some good reasons why Nowotny is omnipresent.

He came to office two weeks before the collapse of Lehman Brothers, the height of the financial crisis. After nearly every bit of gloomy economic news, whether European or Austrian, he is there to reassure in his careful but direct style.

“In times of crisis he wants to get his message across and concerns himself with improving public sentiment,” Handelsblatt wrote. “For Nowotny, economics is also psychology.”

He has been cited on nearly 50 separate occasions by Reuters since Septmber 1. In the same period fellow board members Guy Quaden (Belgium) and Vitor Constancio (Portugal) have been cited  11 times each and given only a handful of interviews between them.

Nowotny tends to talk in a free and general style, according to Gilles Moec from Bank of America, and his comments should be taken as an informed opinion on the state of the economy rather than clues as to future ECB action.

“He’s a central banker but he gives his opinion on what he thinks the economy IS and not really about where interest rates should go.  From this point of view, he is very interesting — he gives an overview.”

Nowotny’s Kenysian slant also means he is slightly apart from the other ECB council members while his belief that it is now more up to fiscal, rather than monetary policy to escape the crisis, is also unusual.

“It’s a very clear-cut approach. He is the only (board member) to my knowledge who tackles this policy-mix issue in a straight-forward manner,” Moec said.

The financial crisis is causing people to do some funny things, but when the head of one of the world’s biggest central banks looks down the lens and tells people to stop being so cautious and go and spend, spend, spend, you know something strange is going on.

Despite European high street stores offering up to 90 percent off, rattled Euro consumers have reacted to the financial crisis by slamming the brakes on spending.

It is not exactly an irrational response. Jobs are being slashed at an eye-watering rate and savvy shoppers know that, as stores become ever more desperate, there is a good chance the
must-have jeans, gadget or new car they have been eyeing may be even cheaper in a few weeks.

So Jean-Claude Trichet, the head of the European Central Bank, decided to take it upon himself at the latest ECB news conference to try a bit of French sales patter after the bank kept interest rates at 2 percent but signalled further cutting was on the way.

“Households are saving more than we would suggest, especially in a number of countries where savings are particularly high,” he said. Rough translation - stop hoarding your money and go to the shops and spend some money so we can get the economy going again.

The evidence is pretty clear cut. Official data showed that Euro zone household savings rose to 14.4 percent in the third quarter of last year, the highest in four years.

It is what is known in economists jargon as the ‘paradox of thrift’ a term coined by Britain economist John Maynard Keynes to explain the fact that people saving more in bad terms only adds to the problem by further sapping demand.

    European Central Bank President Jean-Claude Trichet could not have been clearer about the short-term path of euro zone borrowing costs after cutting interest rates by another 50 basispoints on Thursday to match the historic low of 2 percent.
    “The next important meeting is in March, not February,” he told the ECB’s monthly news conference, signalling a month’s time-out from the current rate cutting cycle. 
    But Trichet’s new buzzword, that the ECB is keen to avoid a liquidity trap, caused confusion among journalists and economists alike.
    After Trichet cited avoiding a liquidity trap four times in answers to questions about how low rates could go, one reporter finally asked him for a definition, leading to the following exchange at the end of the news conference:
    Journalist: What is your exact definition of a liquidity trap? Is it in the Keynesian sense or how do you define it?
    Trichet: It is Keynesian if you wish, but the problem is that experience has demonstrated that once you were there it was very difficult to get out.”
    Journalist: There, where? You mean zero?
    Trichet: A very, very low interest rate.
    Economists saw his comments as confirmation that rates have further to fall, with most tipping a benchmark ECB rate of 1 percent by September.
    But they were puzzled by Trichet’s definition of a liquidity trap — as opposed to the more usual understanding of a combination of economic recession, low official interest rates, a high propensity to save, and deflation making central bank actions ineffective.
    “Since the ‘trap’ refers to the central bank’s inability to revive the economy, you cannot avoid the trap simply by stopping the rate cuts before you hit zero, if you have not yet had an impact on the economy,” UniCredit economist Marco Annunziata said, noting that the solution was unconventional policy such as direct purchases of assets, U.S. Federal Reserve-style.
    So far, the ECB has not embarked on this path, although Trichet says “non-standard action” is possible.

Economists are now certain the European Central Bank will cut interest rates again at its next meeting, the only question is how much.
ECB chief Jean-Claude Trichet’s blunt hint that a rate cut is possible, although not certain, at the next rate meeting on November 6 cemented expectations that the central bank is readying more ammunition to fire at the financial crisis.
Although Trichet would not be drawn on the size of the possible cut, using the past as a guide suggests it could be a repeat of Oct. 8’s half a percentage point reduction.
In June, Trichet flagged a quarter-point rate hike by saying that it was possible, although not certain that the ECB “could decide to move our rates by a small amount” — a qualification that was missing from Monday’s announcement.
   ”The absence of this language in today’s speech, suggests that the ECB President is leaving the door open to a bigger reduction,” Fortis Bank economist Nick Kounis said, tipping a half a percentage point cut to 3.25 percent.
Although the majority of its 25 rate changes have been by only 25 basis points, the pattern shows the ECB is more likely to be bold when cutting rates than when raising them.
Six of the nine rate cuts the ECB has undertaken since 1999 have been of 50 basis points, compared to only two of the 16 rate hikes.
The last two rate cuts, on Oct. 8 and before then in June 2003, were both 50 basis point moves — so the ECB could well go for three in a row.
Some have speculated that the ECB may even cut rates by 75 basis points, although it has never made such a large leap in its 10-year history, either up or down.

Just weeks after the European Central Bank tightened its
rules on the assets banks can use as collateral in central bank
lending operations, it’s thinking about broadening them again.

At a summit in Paris on Sunday, euro zone governments
suggested the ECB follow the U.S. Federal Reserve’s lead in
accepting commercial paper, the short-term debt which many
companies use to fund their day-to-day operations.

Europe’s commercial paper market is worth $800 billion, and
the ECB said it would consider changing the rules on
accepting the paper, which must meet the same high standards
applied to long-term corporate and government debt.

The ECB said on Sept. 4 it would toughen these standards to
stop banks taking advantage of its relatively generous rules and
creating artificial instruments to get their hands on central
bank liquidity.

“What we are going to look at is … how we can widen the terms of our rules to have an even broader system of guarantees than we have today,” ECB President Jean-Claude Trichet said on Sunday.

According to the ECB’s statute, it already has the power to
intervene in markets “by buying and selling underlying assets
outright or under repurchase agreements”.

But analysts said the ECB might be unwilling to use this power
because of doubts about who would foot the bill.

Unlike the Fed, which is backed by the U.S. Treasury, the
euro zone central bank has no government chequebook at its
beck and call.

“The problem in Europe is, who would pay?” said Bank of
America economist Gilles Moec. “Who would play the role of the
Treasury when there is no centralised budget authority?”

“Even if legally they can do it, I think that they would be
reluctant to go along the same lines as the Fed.”