ECB to surprise next Thursday?

Kiron Sarkar lives in London and Ireland where he works as a money manager. His full bio follows below.

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Next week is critical for the Euro Zone. The EU leaders meet on 8/9th December to finalise (hopefully) their proposals for the future of the Euro/ Euro Zone. They need to agree a firm plan to achieve a credible and verifiable fiscal union, with automatic sanctions for transgressors. The absolute necessity to find a solution is even more important, as the EFSF is clearly a failure, in that its “firepower” will not reach the E1tr + previously suggested – closer to half that size is the current gossip doing the rounds. I cannot stress how important this summit is, not only for Europe, but globally.

By way of an example, the rumour on Friday that Spain would be downgraded (inevitable) caused a significant sell of of the Euro – the rumour was denied by Fitch who stated that there was no IMMEDIATE threat of a downgrade – whilst not yet, it will happen, probably relatively soon, is how I read Fitch’s statement.

In a way, it’s the last chance saloon for the Euro and the Euro Zone. The Market is in no mood to give Euro Zone politicians any more time/breathing space. Whilst, a comprehensive and fully implemented policy is impossible to be delivered by the 9th, the Euro Zone can do much – significant parts of the plan have been either leaked or reported in the media and are very much along the lines set out in my recent blogs. However, more on this in a later note.

Equally important is next Thursday’s ECB’s decision. Personally, I believe there is a better than reasonable, though not (as yet) a good chance, that the ECB will surprise and cut interest rates by 50bps (down to 0.75%, from 1.25% presently) rather than just the 25bps, a number of analysts expect. A cut below 1.00% will have a significant impact, as the Market has believed that a 1.0% ECB minimum rate is sacrosanct – certainly true in the past.

The ECB is to publish it’s forecasts for growth and inflation (to include 2013 projections) on Thursday – expect a significant downgrade of growth, combined with weaker inflation forecasts – a perfect scenario to reduce interest rates,  significantly. You will recall that at the last ECB meeting, Draghi justified his decision to reduce interest rates by 25bps by referring to forecasts, as opposed to Trichet’s previous habit of taking decisions based on current data. Based on that, I believe that the ECB will be far more proactive in the future.

Last week, Draghi stated (at the EU parliament) that the ECB is ready to act in cases of both inflation or deflation and/or if inflation is below it’s target of “at or close to 2.0%” – a message, I believe the Market has missed – Suggests a dovish position to me and certainly favours the argument for a more aggressive 50bps cut by the ECB next Thursday. The only argument against, that I can see, is that Euro Zone politicians would not have announced details of their “fiscal compact” at that time, as the key decisions will be announced a day later – on the 9th December.

Mr Stark, an ECB board member, (previously, “Mr Stark raving bonkers”) has also seen the light and has made a number of (surprisingly) dovish statements – he must now be regretting his decision to resign in protest at the recent ECB bond buying. Basically he was WRONG at the time, though most would not regret his departure – there is no place for dogmatic individuals, who are learning on the job, particularly at this very serious time.

Another previous hawk, Mr Nowotny, is also becoming dovish. However, he has become embroiled in a bribery scandal. Hmmmmm. One insight – isn’t it amazing how quickly Mr Trichet’s ludicrous monetary policy has unraveled – thank God. I continue to believe that Mario Draghi is much more switched on and understands markets far, far better than that imbecile Trichet. However, don’t expect Mr Draghi to be communicative – he is, very much, a back room player – fixing
deals in smoke filled rooms seems to be his modus operandi.

The Market remains cautious – no great surprise, given the history of the Euro Zone. However, with Mrs Merkel discovering religion – check out her speech to the German parliament yesterday, (which I reported in my previous blog) – and assuming continued German “control” of the process, I remain cautiously optimistic – pretty weasely words I will admit, but like you, experience has taught me to extremely cautious in all matters relating to the Euro Zone.

Will the ECB do more, such as announce a significant bond buying programme, QE or, for that matter, lending money to either the IMF and/ or certain Euro Zone central banks to on lend to Euro Zone Sovereigns? – lending to Euro Zone central banks is a possible alternative, given likely objections by US republicans to IMF funding – see below. Well, one or more of the above would be great, but, on balance, to early to be delivered I expect. I would guess that the ECB would prefer to wait for the “fiscal compact” that Mr Draghi has proposed needs to be put in place, before embarking on further monetary easing. However, a deterioration in Market sentiment in the early part of next week could force a change in the ECB, I must admit. Mr Geithner is to visit the Euro zone next week, ahead of the 8/9th Dec EU summit. He is to meet a number of senior players, including Mario Monti, Sarkozy and Mr Rajoy, (the Spanish PM elect), together
with Schaeuble and Weidman and the ECB President, Draghi. However, not Mrs Merkel !!! I’m not at all clear as to what he will achieve, particularly as his previous visit was not a sparkling success – the Euro Zone politicians know what they need to do, in particular the Germans.

Interesting developments. President Obama is very keen for a positive settlement of the Euro Zone crisis – he fears an implosion of the Euro Zone as negative for the global/ US economy and therefore his re-election chances. On the other hand, the republicans would prefer a weaker global/US economy. The FT suggests that the republicans will fail in their measures to block IMF support to Europe. The republicans claim that US taxpayers money will be at risk. However, in reality, the IMF, makes money on its lending, its loans ranks in priority to all other creditors  and if they are not repaid, you are talking about a scenario which involves a melt down of the global economy, in which case all bets are off. The republican strategy is also pretty risky politically in the US, I would guess.

A number of US political strategists refer to an US unemployment rate of 8.5% as being the tipping point – above it will be better for the republicans and below, for the democrats. Fridays non farm payrolls, included the results of the household survey, which reported unemployment at 8.6% (forecast 9.0%) and the lowest level since March 2009 – surprising given the November employment gains (120k), together with hours worked and average earnings were either below forecasts and/or unimpressive. In addition, half of the November employment gains were attributed to the retail sector (hiring for black Friday) and temp placements. On a more positive note, Sept/Oct payrolls were revised upwards by 72k. However, it appears that more individuals are leaving the employment Market (nearly 500k), confirmed by the lower employment participation rate (64.0% from 64.2% previously – a near 25+ year low), which explains the lower unemployment rate.

The risks are high, but I believe that Euro Zone politicians understand that, including, most importantly, the Germans. As a result, the odds favour a positive outcome – however, I will watch very, very carefully – it is the Euro Zone after all.

Lower Euro Zone interest rates and a more accommodative ECB monetary policy is negative for the Euro – basically, short term interest rates will converge with that of the US, removing that support for the Euro. Threats of further downgrades of Euro Zone countries (likely re Spain and France) will also weigh on the currency. Furthermore, continuing problems (including further debt write offs/defaults) with Greece are inevitable, as is the certainty that Portugal will have to impose haircuts (in the order of 40%) on it’s debt – it’s current financial position is unsustainable.

By contrast, US economic data continues to improve, whilst Euro Zone data suggests that a number of countries are facing recession, if they are not there already.

Personally, I believe there is a good chance that the Euro will decline much further – to below US$1.20 in the next 3 – 6 months. For full disclosure purposes, I am short the Euro against the US$.

A much weaker Euro is negative for China (as Europe is it’s main trading partner) and suggests to me that the Chinese have a lot further to go in terms of monetary easing. The impact on inflation will have to be watched. Will they go for faster currency appreciation (bad for exports, but better for domestic consumption) to control inflation – far too early to tell, but certainly a possibility. Whatever, the Chinese authorities have no easy choices.

All of the above is equity negative, but in the short term, I expect a further rally, on some sort of resolution of the Euro Zone crisis and the inevitable introduction of QE.

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A qualified UK accountant, Kiron joined the M&A dept of N M Rothschild in London. He was then appointed head of M&A of Rothschild (Hong Kong). On his return to the UK, he was a founding member of the Rothschild international privatisation team. Subsequently headed up the Central and Eastern European (“CEE”) team – rated No 1 in 4 out of 5 years (Privatisation International).

On leaving Rothschild, he worked as privatisation adviser to the UK Governments Know How Fund, which was established to advise Governments in CEE on policy, privatisation, economic, financial, regulatory and other issues. Subsequently European Head of Media, Tech and Telecoms at CIBC World markets. Following CIBC, Kiron advised on telecoms and energy deals in CEE.

Kiron has acted as a lead adviser in respect of over US$150bn of deals and has worked globally in both developed and emerging markets.

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