The European Central Bank President has finally buckled under the weight of bank failures, recessions and slower global growth. Although the ECB left interest rates unchanged at 4.25 percent this morning, Trichet has paved the way for an interest rate cut before the end of the year. This has driven the Euro to the lowest level against the US dollar in more than 12 months and the lowest level against the Japanese Yen in more than 2 years. It is important to realize that this is a dramatic departure from the Trichet’s stubbornly hawkish stance, especially since he raised interest rates as recently as July. It also suggests that he may not be opposed to coordinated easing. If the US bailout plan fails to stabilize the markets, central banks around the world could cut interests at the same time, which would send a strong message to investors and put an end to the weakness in equities.
Unfortunately Trichet had no choice but to be more dovish given the fact that there were 3 separate bailouts in the Eurozone (Fortis, Dexia and Hypo Real Estate Group) and Ireland has fallen into an official recession with Spain and Germany are expected to follow suit.
Only 2 Options – Keep Rates Unchanged or to Cut Them
It was only a matter of time before ECB President Trichet acknowledged the slowdown in growth especially as members of the region struggle with recessionary conditions. In fact, more specifically he indicated that the downside risks have increased and the turmoil in the financial markets complicates their near term outlook. On inflation, the drop in oil prices has allowed him to finally say that there has been a reduction in upside price risks.
In general, Trichet is not a fan of surprises and if he plans on cutting interest rates, he usually tries to prepare the market for the cut by adopting a slightly more dovish tone – which is exactly what we saw today. At the meeting, only 2 options were discussed, leaving interest rates unchanged or cutting them. Raising interest rates is out of the question.
ECB Could Cut Interest Rates by 100bp
The market is currently pricing in 100bp of easing over the next 12 months. The potential expansion in interest rate differentials between the Euro and the US dollar should continue to add pressure on the EUR/USD. The next major support level is not until 1.35.