Here’s why Mario Draghi will backpedal on ECB interest rates

The euro is close to a 6-month high

Mario Draghi might need to change his tune on the prospect for additional rate cuts.

The European Central Bank is back in the spotlight on Thursday, and with no major policy changes in the pipeline, investors will zoom in on any comments that will shed light on whether the ECB chief was too hasty last month in hinting that the institution’s deposit rate wouldn’t be cut further into negative territory.

Following a March meeting that delivered a bigger-than-expected expansion of the ECB’s stimulus plan, Draghi indicated instead that the central bank would focus on delivering easing through the bank credit channel rather than through further cuts in interest rates and a weaker euro. But ECB watchers think he might be forced to change his tune, leaving him to lay the groundwork for taking the central bank’s deposit rate further below zero.

“We believe Draghi will re-open the door for additional rate cuts after stating at the latest meeting in March that he did not anticipate more rate cuts. Draghi is likely to do this by emphasizing the ECB’s forward guidance, stating that policy rates are expected to ‘remain at present or lower levels for an extended period of time,’” analysts at Danske Bank said in a note.

An about-face on interest rates should not come as a surprise to investors. Minutes from the March meeting showed that the supposed tilt away from cutting rates wasn’t quite as dramatic as first interpreted. In the minutes, the ECB noted that a “sharper rate cut could be considered” and that it couldn’t “rule out the possibility and prospect of further cuts if warranted by the outlook for price stability.”

Several ECB officials have since the March meeting also attempted to manage expectations, but without much success. Inflation expectations are still disappointingly low and the euro EURUSD, -0.2641%  has shown no signs of running out of steam. On Wednesday, the shared currency traded at $1.1360, up from around $1.099 ahead of the March meeting and close to the highest level since October.

During the news conference at last month’s meeting, the euro shot higher after Draghi’s rate comments, despite the bank announcing a series of rate cuts, an acceleration of its bond purchases and more cheap loans for banks.

Investors are now left pondering which shocks could prompt another rate cut and when it could happen.

The below chart shows “that the market has clearly started to anticipate some backpedaling from the ECB and has marked short-term interest rates lower again,” RBC Capital Markets said in a note.

“We would not be surprised if Draghi were to try to take back some of the strength of his previous statement and thus allow rate cut pricing to happen. This would probably also prevent the euro from strengthening too much and thus suit the ECB well,” they said.

Analysts don’t expect any rate moves this side of the summer, though, as the ECB is likely to want to see the effects of the recent measures. A Bloomberg survey of 47 analysts predicts the next rate cut will come at the Sept. 8 policy meeting, although some said it could happen as early as June.

Regardless of the timing, Draghi faces a balancing act of calming critics and at the same time keeping the recovery on track. Criticism over negative deposit rates has grown louder in recent weeks, after the central bank yanked the deposit rate to negative 0.4% at the March meeting.

The latest warning fell on Tuesday, when UBS Group AG UBSG, +2.02% UBS, +1.27%  Chairman Axel Weber—a former head of Germany’s Bundesbank—cautioned that the financial system wasn’t designed to handle rates below zero and that it “can substantially change the behavior of consumers and savers.”

The quarterly bank lending survey from the ECB released on Tuesday also showed that negative rates hit banks’ profitability, by hurting their interest income and loan margins.

The ECB rate decision is due on Thursday at 1:45 p.m. Frankfurt time, or 7:45 a.m. Eastern, followed by Draghi’s news conference at 2:30 p.m. Frankfurt time, or 8:30 a.m. Eastern.

 

Source: Market Watch

 

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