By FXEmpire.com
The positive response from the EU members to move forward on the ratification of the fiscal pact is considered the as a step to appease the ECB, as you have to remember that the ECB has been very annoyed by the large loopholes associated with the Growth and Stability Pact over the past decade. Beyond this, the agreement of a direct involvement of the ESM in the recapitalization of the banks once a banking supervisor, likely linked to the ECB itself, is set up will be closely gauged by the central bank.
Immediate positive comments from the ECB president following the summit are encouraging and raise optimism that the central bank will respond to it. However, it remains to be seen if this positive reaction from the ECB president is shared by the rest of the board.
A rate cut will be a minimum response from the ECB. The arguments for such a move are well known: deteriorating business and consumer confidence raising the risk of a new recession in H2, slowing inflation and falling medium-term inflation expectations in the inflation swap market are among them. We would therefore look for a 25 bps cut although there are now calls for even a 50 bps drop.
However, the ECB would be reluctant to deliver such a sharp move as it would be a recognition that it was behind the curve the previous month. The effectiveness of this rate cut could be strengthened by the prospect of seeing the deposit rate also adjusted lower but it is likely to be a close call.
Beyond a Refi rate cut there remains the possibility that the ECB will announce a new LTRO or a reactivation of its bond purchasing program. That would be seen by the market as a strong backing of the EU summit decision by the central bank. Regarding the LTRO, the comments from Mr. Draghi last month suggested that the lack of liquidity was not an issue and therefore the probability to see this policy tool looks low. It is true that looking to the Ted spread (3 month euribor — 3 month German T bill), which is usually seen as an indicator of stress in terms of liquidity, there is relatively little sign of tension.
On the bond purchasing program, it has been almost silent since the LTRO and the ECB made it relatively clear that it wanted the ESM in place on July 9th in order to take the burden on this front, and the capacity to intervene quickly seems to have been enhanced by the recent EU agreement. However, any decision to restart this program to strengthen the efficiency of the ESM will be a strong signal. The justifications would be the same as those used in the past: restoring the appropriate transmission of monetary policy which is the key once again.
However, on these two issues, it means that, as it is between EMU governments, the ECB will likely have to deal with rising divisions inside its board, which increases the pressure on Mr. Draghi for taking a stronger position.
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Originally posted here
