Doubts about Europe’s chance for recovery drives investors to price in ECB interest rate cut

Evidence that Europe’s economic downturn is weighing more heavily on its strongest member, Germany, has convinced more and more experts that the European Central Bank will cut interest rates soon.

The latest downbeat sign came Wednesday from the closely watched Ifo index of German business confidence. It fell to 104.4 points in April from 106.7 in March, more than the modest dip foreseen by market analysts to 106.2. That follows surveys earlier this week indicating Germany’s manufacturing sector is contracting.

The Ifo index remains at a high level, and the institute’s survey chief, Kai Carstensen, said it only means that “the German economy is taking a breather.”

But outside analysts said there was now enough doubt about Europe’s economic recovery for the ECB’s 23-member governing council to cut its key rate from the record low of 0.75 per cent, either at its May 2 meeting or on June 6, when it will have new staff economic projections to help justify any decision.

The ECB’s benchmark, called the refinancing rate, is what it charges to lend to banks. Through them, the rate influences a host of other rates that determine how much it costs businesses and consumers to borrow.

Low rates in theory encourage borrowing to spend and invest, stimulating the economy. A rate cut also can push investors toward buying stocks and other assets, both in anticipation of growth and by making interest-yielding investments less attractive.

Investors prepared for such a move by buying heavily into European stocks. Germany’s stock index is up 3 per cent in two days, France’s almost 4.5 per cent.

ECB President Mario Draghi said in April that the bank remained “ready to act” in case the economic indicators worsened.

In a sign that support for a rate cut may be growing, the head of the German central bank, which has typically been more reluctant to back rate cuts, said last week that a cut could be warranted if economic indicators worsen. Since his comments, they have.

The strength of the German economy is key to the ECB’s rate decisions because of its size—it accounts for 28 per cent of the 17-country eurozone’s total output. It shrank 0.6 per cent in the last three months of 2012.

Germany has been one of the more resilient economies in the eurozone. A slowdown in its economy would make it harder for the region to climb out of recession. The ECB expects the eurozone to contract 0.5 per cent for all of this year, with a gradual upturn near year end.

“Resistance to a rate cut will be crumbling,” said Christian Schulz, an analyst at Berenberg Bank in London, after the Ifo survey was released.

Analysts at Swiss bank UBS have changed their forecasts and now predict an ECB rate cut on May 2. They had previously expected rates to remain unchanged through the end of next year. Analysts at Royal Bank of Scotland and Nomura also shifted their prediction to a cut to the May meeting.

Other signs of trouble in Europe include unemployment at 12.0 per cent, the highest since the euro was introduced in 1999, and auto sales that have fallen for 18 straight months, measured against the same month the year previously.

Analysts say a rate cut might be mostly symbolic and do little to spur lending directly. It could, however, lower the euro’s exchange rate, which would help exporters.

Lower rates can push down the euro’s exchange rate because they lower the yield on many interest-bearing investments denominated in euros. That reduces demand for the currency.

The ECB has also been looking at unspecified new way to help the economy that go beyond interest rates. Analysts say the ECB might take steps to try to increase bank’s willingness to make loans to small and medium size businesses, which provide most of the eurozone’s jobs. Ideas that have been floated include loan guarantees from another European Union agency, or permitting banks to bundle loans to small businesses as securities and use them as collateral to get cash loans from the ECB.
—The Associated Press