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How Long Can the ECB Hold Out?

Another day, another set of dismal Eurozone data points. On 12th Dec. we learned that Industrial Production across the region fell 1.1% in October-it is now down 15% from its pre-credit crisis level. We were also treated to inflation prints from France, Italy and Ireland; 0.7%, 0.7% and 0.3% year-on-year, respectively. Oh, and just to cap things off, retail sales in the Netherlands fell by 1.5% year-on-year.

The same day, Draghi was quick to slap down a suggestion from his chief economist Peter Praet that the ECB could break the potential death-spiral, whereby commercial banks take ECB liquidity and just use it to buy their nations' sovereign debt, by requiring them to hold capital against these holdings. At the moment, they are zero-weighted for this purpose. Draghi said that this change was, 'not a task for now' and that, 'it should be agreed globally'. This is obviously a hot topic within the Governing Council-and so it should be, but this is surely hardly the time to bring up such a suggestion, when the EZ recovery is, 'weak, fragile and uneven', according to the man himself.

Forcing banks to either divest of sovereign bonds or raise more capital will have the no doubt unintended consequence of incentivizing them to lend even less to real people and businesses, or even to each other. One suspects in the real world they would just leave more on deposit at the ECB - a counter-argument to those who claim that taking the deposit rate negative would be futile. Let's stick with the deposit rate for a while; exports of goods and services account for roughly 25% of EZ GDP and the Euro's trade weighted value sits only marginally below its level at the beginning of 2007. Following last week's rather hawkish performance by Mr Draghi at the ECB press conference, it has moved perilously close to 1.40 against the USD. This is obviously the last thing the EZ needs and the best argument for a cut in the deposit rate. Especially so when one takes into account the possibility of EZ deflation, whose arrival a strong Euro will only hasten -ECB staff projections now see inflation at 1.1% next year, with even Netherlands inflation surprising on the downside in November, at 1.2% Y.o.Y., but guess where inflation was higher than expected - yep, Germany.

The Eurozone is fast coming to resemble a one-horse race, with French tribulations the most troubling development. France desperately needs to exit austerity and introduce labour market reforms, but the EZ straight-jacket won't allow it to do the former, and with Hollande in power there is not sufficient strength of philosophical belief in the latter.

So, what is the ECB to do now, given that the cut in the Refinance Rate at the November meeting has had a negligible effect on faith in its forward guidance? Rates implied by December 2015 and 2016 Euribor contracts are a whopping 4bp lower now than they were on the day before the cut.

Last week Draghi made it clear that the ECB was sick of banks using LTRO finance to buy sovereign bonds and that a scheme targeted at SME lending would now be the instrument of choice, rather than the 'traditional' LTRO's to which we have become accustomed. Presumably this would be analogous to the Bank of England's Funding for Lending Scheme, but it seems unlikely to me that this would be deemed 'enough' by the Governing Council, if inflation is falling and growth has become even more 'weak, fragile and uneven', as I would expect.

Taking all of the above into account, I now expect the ECB to cross the rubicon next year, and institute a QE program, (government bonds only), probably sometime in Q2. It ought to come sooner, but the data has to get even worse before a majority emerges on the Council. Maybe a deposit rate cut comes first, as 'unconventional conventional' will be easier to get through.

Turning to the US, what of the recent news that former Bank of Israel Governor, Stanley Fischer, is in line to be proposed as Fed Vice Chair? Much has been made of the disparaging comments he has made in the past regarding the efficacy of forward guidance, but I suspect we can discount this; even if he meant to create such an impression, circumstances change and faced with the need to anchor short-term rates when the Fed tapers, he would climb aboard.

Recent ambiguous initial claims data, (distorted by Thanksgiving), hardly form a firm basis for Fed tapering at its Dec 17/18th meeting, although retail sales figures were undoubtedly quite robust; I continue to expect March, largely due to Fed concerns over disinflation, and still feel if there is a curve ball from the Dec. meeting then it may be an attempt to strengthen forward guidance, without a tapering announcement.

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