ECB Update

Many observers remain convinced that the ECB will ease policy when it meets in March.  The focus is on a small (10 bp) cut in the repo rate from 25 bp. 

Some observers have noted that the new ECB staff forecasts will extend for the first time to 2016.  Some think that a low inflation forecast would be the incentive needed to cut rates. While possible, more likely the ECB staff will provide fodder for the official mantra that inflation expectations remain anchored.  Indeed, this was one of the take-aways from the ECB's survey of professional forecasters.

In other ways, officials cannot be too disturbed by what they see.  EONIA has become less volatile and somewhat less elevated.  Just below 16 bp yesterday, it is well its 20-day average.  Over the last two weeks, it has traded generally between 12-18 bp. 

Excess liquidity in the euro system has also appears to have stabilized.  Bank have slowed their repayment of LTRO borrowings.  Only 1.02 bln euros will be repaid next week.  The four week average is near 1.7 bln euros.  Under its main refi operation, the ECB allocated 93.3 bln euros, which represented a net drain of 1.8 bln euro.  This has been offset, it appears by increased overnight borrowing.  Yesterday banks borrowed 1.05 bln euros overnight, which is the most since September 10. 

Officials also must be pleased with the preliminary GDP reports, where most countries, including Spain and Portugal (and France) surprised on the upside.  They must also happy that despite the German Constitutional Court ruling (and its lack of confidence that OMT is in compliance with treaty agreements), Portugal saw strong demand for its 3 bln euro sale of 10-year bonds earlier this week.  The sale was covered more than three-fold and, importantly, 80% of the issue went to non-residents.  This provides some evidence that the transmission mechanism is beginning to work again.  

Officials are probably just as surprised as everyone else the political turmoil in Italy has not disrupted the Italian capital markets.  Italy's 10 year yield is about 5 bp lower than on Wednesday, the eve of the crisis and within a couple of basis points off the multi-year low.  The same is true for the short-end of the coupon curve. Italian equities are up 1.3% near the end of the session and about 3.4% on the week, making it one of the strongest  major bourses and handily out performing Spain's IBEX (up 0.6% on the week). 

Next week will see the flash PMI reports and the composite is expected to edge higher.  It has been rising since last March.  After pulling back in Q4, it was at its highest level in January (52.9) since mid-2011.   France reports January CPI figures, and a small tick up in the harmonized measures to 0.9% (from 0.8%) is expected.  

The bottom line is that financial and economic developments have been in the direction that will please officials.  The euro's rise to the upper end of the range seen thus far this year may be a bit disconcerting, but the bilateral strength overstates the true case.  Policy makers are more concerned about euro on a trade-weighted basis.  Here it is nearer the lower end of the range it has seen over the past three months. 

A repo rate cut would likely be shrugged off as largely symbolic.  It is not an effective cap on EONIA.  We remain more sympathetic to a cut in the lending rate, the upper end of the rate corridor.  It would not boost lending.  It would not arrest disinflation.