ECB unlikely to cut rates in October

“The case for cutting interest rates at this stage doesn’t strike us as compelling,” says Klaus Baader, senior economist at Société Générale. “Economic growth is weakening but the recent data does not suggest an outright recession and indicates inflation concerns remain elevated”.

While the decline in the economic sentiment index – the summary statistic of five sector surveys – indicates weakening growth, hard data coming out of Germany paints a brighter picture: unemployment is down by 26,000, bringing the rate to 6.9%, its lowest level since reunification in 1991.

Euro-area inflation, on the other hand, looks set to rise, further weakening the case for an interest rate cut. Consumer prices in Spain and Germany both registered higher increases than expected in September and consensus forecasts for euro-area Q4 inflation have risen to almost 3%.

Whatever the latest data says, an ECB rate cut may not be the most appropriate policy measure to mitigate an impending funding crisis in the eurozone banks.

“Risks to the credit supply are hardly coming from an excessively high ECB interest rate,” says Baader. “The real interest rate remains negative. I’m not convinced that the pressing issues in the eurozone would be alleviated by a lower short-term interest rate.”

Rates markets have priced in close to a 16bps cut but Baader expects markets that have priced in an eurozone rate cut to be disappointed and predicts a resumption of non-standard measures specifically targeted at bank funding issues. These could include reintroducing the covered-bond facility, extending bank liquidity facilities to 12 months and further concerted central bank efforts to offer USD liquidity at a lower rate.

With the market still quite short, EURUSD and euro crosses might squeeze higher in anticipation of even mildly positive news. It is difficult to isolate what is priced into currency markets at the moment, but an ECB rate hold coupled with aggressive measures to improve liquidity conditions in the banking sector may see a bounce in th euro.

“If the ECB does decide to hold the policy rate but continues to accommodate on liquidity volumes, I would expect that will contribute to a further squeeze on what might still be excessively short euro positions right now,” says Bob Sinche, global head of FX research at RBS.