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The Bundesbank’s Backhand Endorsement for an ECB Rate Cut

Posted by Joseph Trevisani on May 21, 2014 2:27:00 PM

After breaking one long term trend line on May 9th and another on the 13th, the euro has consolidated between 1.3650 and 1.3725.  But don't expect the bottom to hold for long.

For the past seven trading sessions traders have sold every approach to 1.3725 with the majority of the sales petering out at 1.3700. There have been only two attempts to push through 1.3650, last Thursday which touched 1.3648 and today which got a low as 1.3635. The 200 day moving average at 1.3634 has provided enough support to stall a breakout but not enough to provoke a rally.

The first important Fibonacci level (38.2%) of the July 2013- May 2014 run (1.2755-1.3993) is not until 1.3520.  Although there was substantial back and forth trading between 1.3700 and 1.3550 in January and February that is the immediate technical goal of the euro decline.

Despite Bundesbank and ECB governing board member Jens Weidmann’s statement that a rate cut is not a done deal for the June 5th meeting, recent market action tells us that the ECB is expected, this time to deliver on its rhetoric.

The baseline expectation is for the bank to cut its main-refinance rate from 0.25%.  How much it cuts is probably less important than the fact. A close second is the introduction of charges on commercial bank deposits the so-called 'negative interest rates'.

Mr. Weidmann has always been a skeptic on the ECB's unconventional tools for addressing economic weakness and disinflation on the continent. His doubt that the rate cut is yet approved is, compared to his past opposition practically an endorsement.

After President Draghi all but promised to act at the June meeting, the potential damage to the credibility of Mr. Draghi and the bank if they again do nothing, has probably already enlisted the Bundesbank in Mr. Draghi's schemes.

Mr. Weidmann's most cogent objection, aside from the probable illegality of asset purchases, is that neither lower rates or deposit charges will have any appreciable effect on deflation or euro zone economic activity.

The Fed has been running its massive third quantitative easing program for 20 months now. For a year from December 2012 the Fed bought $85 billion a month in mortgage back securities and Treasuries.  It has since cut back its amount to $45 billion.

During that time U.S. inflation averaged 1.5% annually and ranged from 2.2% in Oct 2012 to 1.1 % this past February.  Even the Fed's preferred measure the core PCE deflator averaged only 1.3% for the period, from 1.8% in October 2012 to 1.1% in February.

There is simply no evidence that quantitative easing had any positive effect on inflation. The Fed's argument is essentially the counter-factual claim that disinflation would have been worse without the central bank’s intervention in the U.S. credit markets. It is backed by the justification that deflation would be so damaging to the economy that any policy to avoid it is warranted.

The Bundesbank knows, as does the Fed, that only a reviving economy, not rate manipulation, is likely to raise inflation to their 2% targets.  But at this point in the drawn out and faltering EMU recovery, the need to do something has become paramount. 

Besides, a weaker euro will certainly help the German economy.

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Charts: Bloomberg

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