European Central Bank to resist pressure on raising interest rates as Eurozone risks remain

The European Central Bank will hold interest rates at a record low of 1 per cent on Wednesday and resist German pressure to flag an exit from its crisis-fighting mode as the euro zone recovery looks increasingly fragile and concerns grow about Spain.

Germany's powerful Bundesbank has led a push by central bankers from the euro zone's core for the ECB to begin preparing an exit from crisis measures that have seen it loosen the rules for tapping ECB funding operations.

The ECB has pumped over 1 trillion euros into the financial system with twin 3-year funding operations, or LTROs, to head off a credit crunch that late last year risked exacerbating the euro zone crisis and jeopardising the currency project.

The German-led group of policymakers is concerned that the wave of cash risks stoking inflation pressures.

Euro zone inflation eased to 2.6 percent in March - above the ECB target of just below 2 percent and higher than expected - but the renewed worries about Spain mean the ECB cannot afford to signal a rate rise or an exit from the funding measures.

“I think the situation is far too fragile for the ECB to meddle in exit strategies at the moment, especially if you look at Spain,” said Berenberg Bank's Christian Schulz, a former ECB economist.

“It's clear the downtrend in yields on sovereign bonds was triggered by the LTROs. If the ECB were to say ‘well, actually now we're thinking about exiting this strategy’, that would cause concern over whether these low interest rates are sustainable. That's why I think they'll be extremely cautious.”

Returns on Spain's 10-year bonds fell to 4.65 per cent in early February, after the first of the twin LTRO operations, but have since risen back to about 5.4 per cent.

A rise in government bond buys by banks in Spain and Italy in February showed they were plying the ‘Sarkozy trade’ - a term adopted by markets after the French president suggested governments urge banks flush with ECB cash to buy their bonds.

This trade helped push down yields on Spanish and Italian government bonds, but the renewed concerns about the public finances in Spain - the euro zone's fourth-largest economy - have sent them higher again.

At Wednesday's post-rate decision news conference, ECB President Mario Draghi will be grilled on how worried he is about the possibility of Spain having to request a bailout after the rise in its refinancing costs.

Spain announced deep cuts to its central government budget on Friday as it battles to convince European partners and debt markets it can rein in its budget deficit in the face of growing complaints from the public. The savings for this year are around 2.5 per cent of gross domestic product (GDP).

WORST OVER?

The ECB believes it has done as much as it can to fight the crisis and Draghi has put the onus firmly on governments to act. They responded last week by agreeing to raise their financial firewall to 700 billion euros.

The ECB is nonetheless concerned that its generous funding operations have made banks too dependent, and wants to wean banks off such loans.

The central bank has an ally on that issue in the European Banking Authority (EBA), which wants banks to stand on their own two feet and at its board meeting this week is trying to come up with ways to encourage them to do so.

The bank dependency concerns and Spanish worries are playing out against a deteriorating economic backdrop across the euro zone. While Draghi said last month the worst of the crisis was over, the latest economic data show the economy stumbling again.

Last month, the economy was hit by a sharp fall in French and German factory activity that even the most pessimistic economists failed to predict.

This means that even though inflation has proved to be stickier than forecast, the ECB is not about to tighten policy any time soon. It had to reverse two rate rises last year as the crisis came back with a vengeance and will be careful not to repeat the mistake of abandoning its low-rate policy too soon.

Analysts have pushed back their view on the next rate move, a Reuters poll showed. They now expect rates to have reached a floor - they equal a record low 1.0 per cent - and tip them to go up late next year at the earliest.

Some economists even believe that, despite pressure from the hardliners to prepare an exit strategy, the ECB will need to cut rates again later this year.

"With more negative news on the economy coming through and probably also inflation to decline further, we still think there is room for lower rates over the course of the year," said Juergen Michels at Citigroup, who expected two more 1/4-point rate cuts this year to take the headline rate to 0.5 per cent.

Copyright Thomson Reuters 2012