Trying To Reverse The Vicious Circle

The first major central bank meetings of the year will tend to dominate market action over the week ahead with a particular focus on Thursday’s ECB meeting as it attempts to rescue peripheral economies from permanent recession, deflation and eventually default. The ECB under new President Draghi has made some important progress in reversing the massive policy mistakes made during 2011. The decision to raise interest rates was extraordinary to say the least and the central bank has reversed these increases with back-to-back cuts to 1.0%. The long-term repo operation has also been very important in helping to ease liquidity pressures.

Nevertheless, confidence in the banking sector is shot with institutions refusing to lend to each other as overnight deposits at the ECB have risen to a record high above EUR450bn. The money supply data remains extremely weak and there is no immediate prospect of reversing the slide in peripheral economies. The change in ECB personnel will be important with two new members on the board following the departure of Stark and Bini-Smaghi. The bank will have a very different feel and is likely to be generally more dovish.

Euro weakness will not be a concern for the ECB. Indeed, they are likely to welcome it as a weaker currency will be a key element if the Euro-zone is to be saved in its current form as there is no possibility that peripheral economies will have the political mandate to deflate sufficiently and cut unit labour costs internally. The ECB will also be extremely mindful of the political considerations and they will continue to resist attempts for open quantitative easing. The most likely outcome is that the bank will prepare the ground for further easing at this week’s meeting.

The Euro-zone banking sector will inevitably be a key focus during the week following the trials of Unicredit and rumours surrounding Deutsche Bank over the past week. The plan must be to keep the sector afloat while capital is raised, but there is still a high risk that a prominent bank will fail which would trigger a fresh spasm of pain for the Euro. Bond auctions will also be watched very closely during the week with key sales due in Germany, Spain and France. A lack of investor demand would increase pressure for the Euro to weaken further. Talks surrounding a second Greek rescue package will also be extremely important as Greece continues to teeter of the brink of default.

The Bank of England has received some favourable survey evidence over the past week with all PMI indices strengthening for the latest month. Although there is a major risk that the data has been distorted by favourable weather conditions, the MPC has further reason to keep policy on hold, especially as it is always extremely reluctant to adjust policy in January.
There are an important series of US data releases during the week with a particular focus on retail sales, due for release on Thursday, and the University of Michigan consumer confidence data on Friday. The majority of US releases have been stronger than expected and there should be further solid gains in this week’s data. With evidence of a stronger labour market, there looks to be little need at present for Fed officials to talk of additional monetary easing. There is still an important risk that the economy will falter quickly as there are still very important vulnerabilities as only a small-scale shock would undermine activity once again.