SCENARIOS-ECB to keep rates steady, clues on exit eyed

17:16 04Nov09 -SCENARIOS-ECB to keep rates steady, clues on exit eyed

FRANKFURT, Nov 4 - The European Central Bank is expected to keep its interest rates on hold at a record-low 1.0 percent on Thursday and keep a cautious stance on the economy.

Since the last rate meeting, forward-looking indicators have added to the hope that the recovery might be quicker than earlier estimated, but hard data is more mixed.

The ECB has cut its main refinancing interest rate by 325 basis points since the intensification of the financial crisis in September 2008. It is expected to keep rates at the current level until the fourth quarter of next year.

Following are different scenarios of what might be decided in the Nov. 8 meeting.


KEEP RATES ON HOLD

The ECB keeps its main refinancing rate at 1.0 percent and the deposit rate, which acts as a floor for money markets, at 0.25 percent.

PROBABILITY: Very high. The latest Reuters poll showed all 78 economists expected the ECB to keep rates at the current level in November. [ECB/INT]

MARKET IMPACT: Given the consensus on the outcome, it would have practically no impact on markets.


CUT RATES

The ECB cuts its main refinancing rate by 0.25 percent.

PROBABILITY: Very small.

MARKET IMPACT: A cut would undermine the euro <EUR=> and could also hurt stocks. Two-year Schatz yields <EU2YT=RR> are seen falling 35-40 basis points to test 1.0 percent, while the yield on 10-year Bunds <EU10YT=RR> may fall 10-15 basis points initially. March Euribor futures may rally by about 30 ticks.


RAISE RATES

The ECB raises rates by 0.25 percent.

PROBABILITY: Extremely small. Positive soft indicators are not enough for the ECB to exit current accommodative policies.

MARKET IMPACT: A rate hike would further strengthen the euro. It would add to stock market volatility as the move could be taken as a sign that the recession is over and the central bank sees a rapid recovery -- or that the ECB is out of touch. Two-year Schatz yields are seen rising 20-25 basis points while Bunds may rise slightly less, eyeing the 3.5 percent level. March Euribor futures prices will likely fall to factor in a cash rate of around 1.5 percent by March next year.


SAY "RATES APPROPRIATE"

Trichet repeats that interest rates are at an appropriate level, reinforcing the consensus that rates are going to stay on hold for some time.

PROBABILITY: Very high.

MARKET IMPACT: Omitting this phrase would trigger speculation of a rate hike sooner than the fourth quarter of 2010, as economists currently expect.


WARN ON LARGE FISCAL DEFICITS

Trichet could plead for fiscal consolidation as soon as there are signs of the economy recovery.

PROBABILITY: High. The question is more how far Trichet will go -- he could join fellow policymakers who have made it increasingly clear that interest rates could stay low for longer if government spending is reined in in a timely manner.

MARKET IMPACT: Clear signals that rates have to rise sooner if deficits continue could hit the stock markets and depress bond prices. Could also strengthen the euro.


OUTLINE EXIT STRATEGY

The ECB could present details on how it plans to unwind its support for the economy, which remains an open question. Policymakers have not said whether the ECB will first raise rates or withdraw liquidity, or when it will act. However, Governing Council member Axel Weber hinted last week that the ECB would roll back unconventional measures next year.

PROBABILITY: Low. While policymakers will very likely discuss exit strategies, they have not shown many signs of consensus on the right timing of withdrawing support, let alone how it will be done. But Trichet is likely to stress the ECB is committed to unwinding measures before inflation pressures rise.

MARKET IMPACT: Large. Signs that inflation hawks were dominant in the ECB would hurt bond prices. The euro and stock prices could rise if this was taken as a vote of confidence in the economy. Two-year Schatz yields could rise towards 1.50 percent on expectations of rate rises while Bund yields ould rise towards 3.5 percent. March Euribor futures are likely to fall 15-20 ticks.


ANNOUNCE AN END TO 12-MONTH REFIS AFTER DECEMBER

Trichet could say the ECB will not conduct any more 12-month refinancing operations after the one scheduled for mid-December. Weber hinted last week that these might be the first non-conventional measure to go, while full allotment at weekly refinancing operations should stay, he said.

PROBABILITY: Moderate. While many analysts tip that the ECB will stop this measure, the ECB might want to wait until December to make the announcement.

MARKET IMPACT: Market interest rates could rise and the yield curve steepen, but the impact would be muted as ending the 12-month refis would be less of a surprise than the timing.


TALK OF THE ECONOMIC OUTLOOK IN MORE POSITIVE TERMS

The ECB could change the wording of its economic outlook. For example, it could say economic stabilisation is progressing well instead of saying the euro zone economy is stabilising.

PROBABILITY: Unlikely to project fundamental change in economic assessment. While the ECB is in the habit of tweaking the wording slightly every month, it will want to see more data before a notable upgrade. It is likely to save changes for December, when new staff economic projections are released.

MARKET IMPACT: Moderate to large, depending on the wording. The euro and stock markets would likely rise were Trichet to sound more positive on the economy, but bond prices could be hit, especially if the statement were accompanied by talk of inflation rearing its head.


COMMENT ON THE STRONG EURO

The euro is flat against the U.S. dollar <EUR=> since the last rate meeting, but trades about 16 percent higher than eight months ago. Some economists have said the stronger euro could hamper economic recovery in the euro zone, but ECB policymakers have shown less concern. On a trade-weighted basis, the rise is less steep than on previous occasins.

PROBABILITY: Moderate. If asked on foreign exchange, Trichet is likely to repeat that excess currency volatility is bad for stability and that U.S. support for a strong dollar is important. He could say something specific about the Chinese yuan exchange rate, but is unlikely to ratchet up his rhetoric.

MARKET IMPACT: Were Trichet to state current exchange rates do not reflect economic fundamentals or describe recent increases as "brutal", this would likely weaken the euro. Just sticking to his usual talking points would have little impact.