ECB Rate Increase Is Less of a Done Deal as Japan Disaster Aftermath Looms

Investors and economists are paring bets that the European Central Bank will raise interest rates next month as the aftermath of Japan’s biggest earthquake overshadows prospects for the global economy.

Money-market futures fell, indicating investors are curbing expectations that the ECB will proceed with lifting borrowing costs after stocks, bond yields and commodities slumped on concern a nuclear disaster is unfolding in Japan. Economists at Nomura International Plc, Lloyds Bank Corporate Markets and Royal Bank of Scotland Group Plc said the ECB may wait to assess the impact on markets and the global economy.

“The ECB is still more likely to raise rates than not next month, but it’s by no means as much a done deal as it was,” said Laurent Bilke, head of global interest-rate strategy at Nomura International in London. “It could risk really spooking markets and exacerbating panic. There is just so much uncertainty around.”

ECB President Jean-Claude Trichet surprised investors 12 days ago by saying that the central bank may tighten policy for the first time in almost three years. The ECB is concerned that inflation, which has breached its 2 percent limit since December, may become entrenched as workers demand wage increases to compensate for higher costs.

“The probability of an increase is somewhere between 50 and 75 percent now” instead of maybe 90 percent before, said Kenneth Broux, senior market economist at Lloyds Bank in London. “The deeper the selloff in risk, the greater uncertainty and the more bad news from Japan, the more likely they’d wait to understand to discover the implications.”

Rate Survey
A survey of fund managers published today by Bank of America Merrill Lynch found 72 percent expect the ECB to raise rates before July, up from zero in February. The poll was taken before Japan’s earthquake and the agreement by European leaders to let their bailout fund buy bonds from governments.

“Maybe investors are being too aggressive in terms of the ECB rate rise,” said Gary Baker, head of European equities strategy at BofA Merrill Lynch. “Markets would still be expecting a rate rise, but it’s not a foregone conclusion.”

German investor confidence fell for the first time in five months in March on expectations of a rate increase and after the earthquake, the ZEW Center for European Economic Research in Mannheim said today. Its index of investor and analyst expectations, which aims to predict developments six months in advance, declined to 14.1 from 15.7 in February.

‘Too Early’
ECB Governing Council member Ewald Nowotny said yesterday evening that it’s “too early” for any conclusion on how the Japanese disaster may impact officials’ resolve to raise rates. Nowotny said “we never pre-commit” and developments have to be “observed very closely.”

Forward contracts on the euro overnight index average, or Eonia, for the day of the next ECB interest-rate decision fell four basis points, or 0.04 percentage points, to 0.9205 percent as of 3 p.m. in London, according to data from Deutsche Bank AG. The declines indicate investors are paring bets on an increase in borrowing costs next month.

The 10-year German breakeven rate, a measure of inflation expectations, fell for a fourth day, declining three basis points to 198 basis points. The rate climbed as high as 215 basis points on March 3.

Euribor futures jumped today, sending the implied yield on the contract expiring in December down 15 basis points to 1.88 percent, signaling traders are reducing bets for higher interest rates in the euro area through the end of the year.

‘Extreme Situation’
Even so, holding off “would completely dilute and erode any impact of signaling rate increases in the first place,” said Julian Callow, chief European economist at Barclays Capital in London. “They’ve only done that once in 2007 and at the time the situation was critical, money markets had completely frozen plus they had already raised rates quite a bit.”

Europe’s economy is gathering strength, with manufacturing growth accelerating to the fastest pace in more than ten years in February and confidence in the economic outlook jumping to the highest in more than three years last month. Inflation has reached 2.4 percent and it will stay above its ceiling for the whole of 2011, the central bank said in its latest forecasts.

The effect of Japan on financial markets and the global economy may yet override the ECB’s determination to curb consumer prices, said Jacques Cailloux, chief European economist at RBS in London.

“What’s happening in Japan is significant,” he said. “It has more implications for damping global demand in the medium term so reduces the chances of rate hikes post-April, but you cannot rule out an extreme situation preventing them from raising rates” in April.


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