Morgan Stanley On The REAL Motivation Behind Trichet's Tough Talk On Interest Rates

The chatter in the monetary policy world continues to revolve around Jean-Claude Trichet’s warning that ECB rate hikes are coming soon.

The consensus is that there will be three by the end of this year. Roubini’s shop, RGE Monitor, is on board with this view.

Why is Trichet talking all tough?

Morgan Stanley, which had anticipated a dovish ECB up until Trichet’s comments, tries to get inside his head.

Their conclusion: With the ECB basically forced to continue propping up the PIIGS, a warning about higher rates is essentially all Trichet has to flex his muscle.

Here’s Joachim Fels:

We see three implications from the ECB’s tougher stance for Europe.

First, this puts pressure on banks and peripheral governments as their funding costs go up. While the ECB continues to provide unlimited liquidity to banks and is still buying government bonds in ‘dysfunctional’ markets, higher rates mean that the liquidity and new funding become more expensive. Together with a (likely) disappointing outcome of the late March EU Summit, this could lead to another intensification of the debt crisis over the coming months.

Second, a hawkish ECB could push the euro significantly higher. In fact, our FX strategists have revised their euro forecasts significantly higher across the board on the back of the ECB surprise (see FX Forecast Changes, March 6, 2011).

Third, higher funding costs for banks combined with a stronger euro increase the downside risks for the European economy, especially in the periphery.

The last point is especially important, because it sets up this situation whereby the euro is fundamentally strong and weak at the same time.

It’s strong because compared to his counterpart in the US, the ECB is increasing rates. And its weak because higher rates only exacerbate the structural problems facing the EU member countries. Hence, as we put it yesterday, there are two kinds of European hawks — the ones that talk tough on rates (Trichet) and the ones that talk tough on bailouts (Axel Weber). When the former talk, its euro bullish, and when the latter talk its euro bullish. Should be a good recipe for a wild ride, especially over the coming month as European leaders meet at the EU summit.

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