The ECB will push the pedal to the metal tomorrow
The second wave of the coronavirus pandemic is putting pressure on the eurozone economy, and rising spreads on EU member states' government bonds may increase the price of loans, which are especially needed at such a difficult time in order to kick-start economic growth. The ECB promised a monetary stimulus at its last meeting in November, and the markets are full of expectations that the bank will deliver what it promised. Draghi's famous "Whatever it takes" therefore continues.
The ECB will monitor spreads
In March, ECB President Christine Legarder said that reducing the spread on borrowing costs between stronger and weaker eurozone countries was not the work of the ECB, putting pressure on the bond market. Nine months later, investors are betting that the ECB has changed its mind and will close the spreads. The ECB will meet tomorrow and spreads are already being squeezed by growing demand for riskier bonds. Portugal's bonds fell below 0% for the first time in history, with Spain and Italy following closely behind. It is at a time of pandemic that borrowing costs need to be kept as low as possible to ensure a smoother expansion in the economy.
However, tomorrow's ECB meeting will not only interest investors in the bond market but also in the stock market. Tomorrow, the bank is expected to expand the quantitative easing program, which now amounts to 1.35 trillion euros, by another 500 billion euros. With the gradual decline in market risks, money will now spill over into much riskier countries, where investors will find much better returns, as the ECB is behind it all. It is the decline in risk premiums in the markets that could gradually kick-start some sectors in Europe that have failed to recover from the pandemic sale. For example, the DAX index still has room to fill the gap between record highs that many investors are certainly looking for.
The ECB is doing something similar to the Fed. It is a kind of control over the yield curve and yields spreads. In this, however, the ECB has much more confidence from investors than, for example, in maintaining the price level in the euro area, which is expected to rise by only 1.25% over the next ten years.
Intervention on the euro?
The recent strengthening of the euro is not good news for the ECB, which is fighting deflation. The stronger euro is pushing down import prices and is now at its highest since April 2018. This is largely the result of a weaker US dollar, but investors are still skeptical about whether the ECB will come up with something that could push the euro down. Verbal intervention is could help, but the problem is that it only works for a short period of time.
A reduction in interest rates does not seem to be on the agenda, although some investors expect such a step, but it would be a big surprise. It is the reluctance to reduce rates that drives the euro higher. The bank is likely to stick to buying bonds and will hope that other countries will increase their government spending, which would help trigger inflation. The most likely scenario is another urgency from Christine Legarder for the need for fiscal stimulus. We do not expect a response from the euro anytime soon.
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