A Forex View From Afar

Can The ECB Cut More Than Expected

Tomorrow morning every market participant expects the ECB to reduce the overnight lending rate by 50 basis points, down to 1.50%.

The road to such a low rate was somewhat lengthy for the European Central Bank, compared with the other major central banks, of which almost all are preparing to adopt a quantitative easing strategy.

Until now, the foremost members of the ECB’s voting council have excluded the possibility for very low interest rates. In their opinion, low, real, inter-banking rates would create a liquidity trap, which means that the central bank would reach the limits of monetary policy. At the same time, a liquidity trap would drain any lending in the inter-banking system because of the losses banks would have to take when they borrow or even when they lend. In other words, it would be cheaper for the bank to keep the money for itself than to lend it to another bank, something that has widespread negative effects in the real economy.

For this reason, the Eonia Swap market is pricing in a 0.75% interest rate in the following 3 to 12 months, after which traders expect the bank to begin to slowly raise the key interest rate. Interesting enough, the same Eonia Swap rate, which to some extent is the future market for the ECB rate, began to price in a 1.25% interest rate for tomorrow’s meeting, since the last part of January.

This means that the spread between the forecasted interest rate and the 1-week Eonia Swap rate is -25 basis points, the largest in the current rate cut cycle. This is a sign that prime banks, the ones that trade in the Euro-area inter-banking system, expect the ECB to cut 75 basis points tomorrow. At past meetings, the spread between the two rates was positive.

Also tomorrow, the ECB is expected to update its growth and inflation projections for 2009, also known as the “staff projections”. As has been announced by Mr. Trichet in his speeches, the forecasts will be downgraded considerably from the previous numbers, something that might have a negative effect on the euro’s valuation

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