ECB Expected to Cut Rates, EU Summit Waits in Wings

The European Central Bank is widely expected to cut interest rates back to a record low of 1 percent from the current 1.25 percent on Thursday and provide longer-term loans to banks that are struggling to find funding.

The ECB's meeting is a prelude to the closely-watched summit of European heads of state on Friday. Expectations that the leaders will agree to treaty changes to alleviate the sovereign debt crisis are high and investors hope that will pave the way for a more aggressive ECB response to the crisis.

Weak economic data, including business surveys which suggest a sharp contraction in the fourth quarter, have strengthened the case for a rate cut, economists say.

Figures published on Tuesday showed the euro zone economy grew by just 0.2 percent in the third quarter.

“There’s no question that the ECB will do what it can. It will cut interest rates. It will probably give a signal that it is prepared to go below the 1 percent floor that it held at during the global financial crisis,” Simon Grose Hodge, Head of Investment Advisory at LGT Bank told CNBC on Wednesday.

The extra liquidity provided by the central bank during the crisis would be kept in place as long as it was needed, he said.

Many banks fear other financial institutions will not be able to repay their loans and are therefore reluctant to lend to them, meaning they are increasingly turning to the ECB for funding.

Use of the ECB’s emergency funding facility has been unusually high in recent weeks.

Reuters reported on Thursday morning that overnight emergency borrowing by commercial banks jumped to over 9 billion euros ($12 billion), the highest since the beginning of March this year.

“We expect the ECB to provide additional support to banks in the form of a softening of collateral rules and more and longer liquidity operations,” Barclays analysts said in a note.

Financial markets received a shot in the arm last week when central banks launched a joint effort to reduce the cost of temporary dollar loans to banks, and on Tuesday the Bank of England launched another new facility to provide sterling liquidity which it says is not necessary yet.

“The central banks are on the ball. They are making sure that markets at least stay functional. But none of that is solving a problem. It’s just putting in a safety net to make sure things don’t get even worse,” Grose-Hodge said.

Analysts at UBS pointed out that rate cuts were not the most important measures in tackling the crisis.

“Banks need visibility on medium and long term funding,” they said.

The Bank of England also concludes its two-day rate-setting meeting on Thursday, and is expected to will keep rates on hold at 0.5 percent and leave its asset purchase target unchanged.

More Active ECB?

Many politicians, within and beyond Europe, would like the ECB to take a more active role in tackling the debt crisis by buying bonds from euro zone states who have effectively been shut out of the debt market by high yields.

The ECB launched a bond - buying program – the Securities Markets Program or SMP which buys bonds in the secondary markets to ensure a smooth functioning of financial markets - in 2010 and investors will be scrutinizing comments by ECB President Mario Draghi’s for any signs that the bank will ramp up the facility .

“On Thursday, the ECB's Draghi spoke at the European Parliament and made it clear that the SMP program is only temporary and not unlimited. Still, the main signal was that the ECB might be more aggressive in the bond purchasing in the secondary markets if the euro countries commit to deeper fiscal discipline,” analysts at Danske Bank said in a note to clients.

The ECB has made it clear it will not step up as a lender of last resort until EU leaders agree on a form of fiscal union and with the EU summit waiting in the wings, ECB President Mario Draghi is unlikely to announce greater commitment, analysts said.

“I don’t think we’re going to see full-blown QE (quantitative easing) announced on Thursday. I think we’ll see a cut in rates. Probably a quarter of a percent. A 20 percent chance of a half a percent cut,” Nick Beecroft, senior market consultant at Saxo Bank said.

“I think the cogs will be whirring towards a form of QE, a virtually unlimited commitment to buy peripheral bonds. But I don’t think that will be announced this Thursday,” he said.