ECB interest rate cut sends euro to 2012 low

Welcome to my weekly account of movement in the foreign exchange rates.

So just one week has passed, and you might be forgiven for thinking that there was no EU summit at all last Friday. Because today, the yield on Spanish bonds again sits at 7.00%. The pound meanwhile (at 1.2560) is at its highest point against the euro since October 2008. Pessimistic business as usual for Europe then, when just seven days ago the outlook looked much rosier. So what’s happened?

This week, the reversal in Europe’s fortunes can be attributed squarely to the European Central Bank. Speaking yesterday, its President Mario Draghi said things that not just implied the future impotence of the ECB to aid the Eurozone (when so far, it’s been the only entity capable of lifting sentiment.) He also stated that Europe’s recession is likely to get worse.

To basics then. Mr. Draghi cut Europe’s benchmark interest rate -0.25% to just 0.75%, a record low for the ECB. The idea here is to make borrowing cheaper for European businesses, and so encourage the flow of credit.

Interestingly, the ECB president stated that this will benefit all the Eurozone’s economies. This marks a break with the past, when the inability of the ECB to tailor interest rates to each Eurozone member’s needs was a point of contention. Now, even Germany (which favours high interest rates to fight inflation) could benefit from this cut. This indicates that Europe’s economies must sink or swim together.

Yet, even as he reduced interest rates, Mr. Draghi forecast that the impact of such a cut would be minimal.

Indeed, Europe’s problem is not a lack of credit: the ECB has pumped €1 trillion into Eurozone banks since January, in part to make sure it’s widely available. Instead (though he didn’t say this) the problem is confidence. Given the uncertain future of the continent, businesses are unwilling to borrow and invest. (This is precisely the same dilemma the Bank of England faces, which has been much more aggressive in getting lending going, without success.)

Hence this cut in interest rates is more a gesture than a determined move to spur growth. Yet this alone is not responsible for the market’s pessimistic view of the Eurozone. Instead, what drained the blood from the face of investors was the prospect of a deepening recession. Mr Draghi said: “the risks surrounding the economic outlook for the euro area continue to be on the downside”.

In a sense, this should be obvious to anyone who has paid attention. Spain and other indebted nations have been making reforms that, because of their nature, take time to bear fruit. To suggest that the Eurozone economy will be bouncing around inside a month is therefore unrealistic.

Yet the markets are not rational at the best of times. So Mr. Draghi’s comment, which should have seemed obvious, instead prompted panic. Hence the widespread sell in the euro, as well as the rise in Spain yields. Is it right? No. Does it make sense? No. But it is unfortunately the situation in which Europe finds itself.

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