Euroland: Weber Confirms Shift in ECB Focus

Overview: There were two interesting takeaways from a speech by ECB's überhawk Axel Weber in Malaysia last night. First, ECBs caution of lowering rates too much has taken a back seat in our view - as already suggested by Trichet on the ECB meeting last week (see Flash Comment: ECB keeps door open for further easing). This makes a 50bp cut on the March meeting more likely and the chance of further easing during Spring is definitely there. We will release new rate forecasts on Friday and will likely revising down the path for ECB rates from our current scenario of 50bp in March being the last cut. Second, Weber highlights the importance of a symmetrical policy approach where rates are changed at the same pace in both directions. This suggests that rates will be raised faster than "normal" once the cycle turns.
Details:

1. No longer a limit for easing: The change in tone from ECB from the press conference last week was today confirmed by the German ECB member Axel Weber who said that "We should not at this point avoid to lower rates aggressively, because we understand at the current juncture all indica-tors look like the economy is in free-fall." Just 3 weeks ago ECB had talked about avoiding a liquidity trap suggesting that it would somehow be dangerous to cut rates too low. However, this view had already been challenged within ECB by the Cypriote member Orhpanides who on 29 Jan said that "A central bank with a policy rate that is positive but rather low might be incorrectly advised to 'save its ammunition' so that it may still be in a position to ease policy later on. It may be desirable for central banks to take forceful and pre-emptive interest rate action aiming to minimise the probability that they may later find themselves in a situation where they will be forced to resort to unconventional policy easing" It would seem as if Orhpanides is gaining increasing support for his views within the Council. As the hawk he is Weber continued to highlight, though, that policy should be guided by the medium term and that the expansion of money could be inflationary in the longer run. However we see this more as a sign that policy could be reversed more quickly. Which leads to the second takeaway...

2. Symmetry of monetary policy: Weber had some interesting comments regarding how the stimulus is taken back eventually: "A more symmetrical approach to monetary policy will better alleviate the negative effects of the financial cycle than a monetary policy approach that solely tries to limit the damage in times of a financial downturn by aggressively lowering interest rates." Weber goes on to say that "A symmetrical monetary policy would consider a higher key interest rate in the event of an increase in risk in the financial markets, even in the absence of inflationary risk or macroeco-nomic risks within the usual time horizon for monetary policy." Weber probably refers to the issue that the "risk management" approach which Fed have subscribed to has mainly focused on risks to the downside. If rates are not raised in the same way when downside risks disappear - or when risks are to the upside- then rates will end up too low. As the chart on the next page shows this has created a long downward trend in the real Fed funds rate with the peaks of the tightening cycles be-ing lower and the bottoms in easing cycles also being lower. The pattern is also there for ECB but not to the same degree. In hindsight ECB would probably have liked to raise rates faster in the lat-est tightening cycle - rather than using very gradual steps. The conclusion from this is that rates will likely be raised faster when this cycle turns in order to get back to a more symmetrical ap-proach. The lesson ECB draws now seems to be that low rates in itself is not a problem. But if rates are kept low for too long it creates excessive risk taking and future problems.

Market implications: It has become harder to judge what is priced from ECB given the both euribor and eonia rates are distorted. We estimate that the market is currently pricing something between 50 and 75bp of further cuts. Given the latest comments we see some risk that ECB could cut more than that. Looking at a model for 2y yields versus the refi rate also suggests that there is still some value left in 2y German bonds at the current yield of 1.43% (see right chart below). 10y bond yields, however, is still un-der pressure from heavy supply and an eventual faster turn in the monetary cycle also means that 10y yields should be higher - all else equal. This supports the case for further yield curve steepening. A more dovish ECB will also support a further weakening of the euro.

Danske Bank
http://www.danskebank.com/danskeresearch