The hype surrounding the Twitter IPO on Thursday this week masked the news coming out of Europe of the European Central Bank rate cut. The ECB cut its main refinancing rate by 25 basis points to 0.25%. Although technically a "surprise" since by mid-week most analysts expected the bank to stay on hold, the potential move had been talked about by us last week as a European unemployment report came in unexpectedly high and inflation was reported at four-year lows at 0.7%.
Market reaction was fast and sizable. The euro dropped over 1% immediately. European equities, which had been on the soft side, rallied, and bond yields fell. What is interesting though is that markets had become almost certain last week that a rate cut would happen – it was just a question of when - this meeting or one in December. In addition to the timing, markets are always looking ahead to the next move, and with the ECB's historical reluctance to easing monetary conditions too aggressively, many analysts were already on record saying that the next ECB move after this would be a hike, albeit not for another year or more.
So the debate begins as to why this ECB President Mario Draghi orchestrated this move. To put it mildly, it is a gutsy call. The ECB definitely did not keep its powder dry and it begs the question as to how the bank will maneuver in 2014 if the euro zone fails to see an improvement in growth. Mr. Draghi could look at Fed-style quantitative easing or even negative deposit rates, but those are very politically sensitive policies.
My View: What may have prompted this move is the recent euro strength in the 1.35 area. An analysis by Bloomberg this week shows that the euro is close to being properly valued for the core countries like Germany but way overvalued for the peripheral countries. Delivering this cut under the cover of a low inflation report allowed the ECB to throw those countries a bit of a lifeline. It was a shrewd move by Mr. Draghi – taking a really tough hand dealt to him and getting the most value out of it. Super Mario is getting a good reputation for this in the market.
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