Our monthly interest rate and foreign exchange poll suggests that the European Central Bank (ECB) will maintain the refinance rate at 1% for the foreseeable future. The ECB has cut its refinancing rate seven times between December 2008 and May 2009. Key rates are likely to remain unchanged as the European Union (EU) struggles with deficit and debt crises in several member states that have raised the question of its cohesion. Central to these concerns is Greece which is struggling to reduce the EU’s largest fiscal shortfall from last year’s 12.7% of gross domestic product. The Greek government has pledged to reduce the deficit this year by 4 percentage points of gross domestic product.

ECB officials have tried to reassure markets saying that the Greek government is capable of adhering to strict fiscal guidelines to cut its deficit, while carefully avoiding any direct comments on a potential bailout. The country, which already faces high borrowing costs due to widening bond spreads, faces possible downgrades from the rating agencies in the coming months. The fall-out from the crisis has resulted in a sharp revision of euro/dollar forecasts among our surveyed economists. The average median forecast for 2010 has dropped from 1.45 last month to 1.37. BNP Paribas has the worst outlook for the euro with a forecast of 1.33 in 2010. German Chancellor Angela Merkel said on March 5 that the Greek government now has a credible fiscal programme with 4.8 billion euros of additional deficit cuts.

Slower relative growth in Europe

The euro/dollar exchange rate is also being shaped by expected changes in bond yields in the United States and Europe. The polled economists suggest that the ECB and Federal Reserve will march to different monetary rhythms with rates consistently higher in the US. The median forecast for 10-year US government bonds in 2010 is 4% compared to 3.56% in the Euro region and 4.47% in the UK. This month’s forecasts also show a sharper increase in 10-year rates in the US than in the Euro region from a month earlier. The upward revision for the median 10-year yield from a month ago is 8bps in the US, compared to a 1bp drop in the Euro region.

The Federal Reserve raised the cost of direct loans to banks (the discount rate) by a quarter point to 0.75% February 18, the first increase since June 2006, building on bullish pressure for the dollar. Chairman Ben Bernanke has since cautioned that the recovery remains nascent and still requires low interest rates. “The move to raise the discount rate should be viewed as part of a process to unwind measures implemented to counter the financial crisis,” notes Bruce Kasman, economist at JP Morgan Chase. “The next step on this path will be the completion of the agency MBS purchase plan in March. These steps taken to end unconventional easing are not intended to signal that the rate normalisation process is close at hand.” Even if they are not, the Fed’s move to raise the discount rate is being interpreted broadly as presaging an eventual policy shift before the ECB.
In the Euro region, the case for an eventual tightening has been pushed out into the distant future by forecasts of slower relative growth and falling confidence. European confidence in the economic outlook unexpectedly worsened in February with the European Commission reporting February 25 that an index of executive and consumer sentiment in the 16 countries using the euro dropped to 95.9 from 96 in January. Economists were projecting an increase to 96.4. Europe’s economy may grow 1.6 percent this year, lagging behind a global expansion of 3.9% and US growth of 2.4%, according to the International Monetary Fund.

Consensus March 2010

VB