Why the ECB is right not to cut rates

The ECB kept rates on hold today at 1%. Some in the markets had expected rates to be cut, and there seems to be growing pressure for the ECB to do something, for example cutting rates since sovereign strains have emerged and appear to be engulfing Spain.

However, we believe that cutting rates is not the answer. Interest rate expectations are already low with rate expectations for three months ahead as priced by the options market, which is already close to pricing in a 25 bp cut from the Bank. Thus, one cut by the Bank would have little impact on the euro, as it is practically priced in already.

Added to that, real interest rates, when adjusted for inflation are actually -1.4% (CPI is currently 2.4%). Rates are probably too loose for Germany, although they remain too tight for peripheral nations like Spain. However, since the Bundesbank is a powerful element in the ECB and it remains extremely hawkish, it's hard to see the Bank agreeing to a rate cut when real rates are already negative.

But the main reason we think that rates should not be cut is that we don't think a cut would have a big impact on the markets or the struggling Eurozone economies as they go through a tough period of austerity. The fiscal adjustment has a long way to go, and this is causing households to retreat from borrowing and spending.

In a country like Spain this adjustment to household balance sheets over the last 2 years is equivalent to approx. 14% of GDP. If austerity remains in place then even if rates are cut by 25 or 50bps it would not necessarily be enough of a carrot to get businesses and individuals borrowing, and most importantly, spending again.

We believe a more effective way to get tackle the current crisis is to re-start the SMP programme. Since the latest outbreak of the sovereign crisis we have seen Spanish and Italian bonds come under pressure, but other "core" members of Europe including France, Austria and the Netherlands have seen their bond yields fall in the last few months as you can see in chart 2 below.

Thus, if the ECB could buy Spanish and Italian bonds it would be targeting the epicentre of the problem and could help reduce overall credit risk and mitigate the market concerns in the latest flare up of this crisis. However, although we think this is the most effective course of action we doubt it will be enacted due to resistance from the Bundesbank and also the fact the ECB is not allowed to re-capitalise governments directly.

Hence we get another month, another ECB meeting and no progress on stemming the latest flare-up of this debt crisis. The ECB has passed the baton to the EU governments to sort this crisis out. This leaves the markets waiting for the Greek election result on the 17th June and the EU summit at the end of this month to try and get some concrete action to sort this crisis out. Thus, the markets are likely to remain jittery and vulnerable to headline risk in the coming weeks, which makes a decline back to the 1.20 zone in EURUSD possible.