MORGAN STANLEY: Why the European Central Bank may raise rates sooner than expected

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While investors are focusing on the pace of US rate hikes and possible tapering in the eurozone, Morgan Stanley is advocating the real monetary policy surprises could actually lie elsewhere — higher European Central Bank rates.

In a note from the economics team, they ponder whether markets, until recently, have been too complacent when it comes the US Fed not reducing the size of its balance sheet as well as the ECB for not raising its deposit rate until well into next year

Here are four reasons why Morgan Stanley thinks the ECB may hike:

1. Euro weakness offers ECB head Mario Draghi room: The euro has lost ground in the global currency market in the wake of the greenback’s strength and tepid economic conditions in trading bloc. This offers the ECB room to hike interest rates.

AUD/USD Daily Chart

2. Link between asset purchase and deposit rates severed: With the December decision to buy bonds below the deposit rate, the ECB severed the link between its asset purchases and the deposit rate. Hence, it is no longer necessary for the central bank to wait until the end of quantitative easing before it can think of raising rates.

3. Easier to change interest rate forward guidance: Morgan Stanley thinks it would be easier for the ECB to change its forward guidance on interest rates than to go back on its policy announcement on a steady pace of asset purchases until December. Once the Governing Council is ready to change its risk assessment away from the downside economic risks it currently sees, it might amend its forward guidance on interest rates.

4. June may be the time: To expect such a shift already at the early March meeting might be ambitious – even though Morgan Stanley expects economic growth to accelerate in early 2017. By June, however, the Council could feel more comfortable with a balanced risk assessment.

The investment bank did flag some risks to its view, primarily its comfort with financial conditions and whether higher interest rates could lead to a “material tightening” of money supply access. This would depend on exchange rate developments and on the likely impact on credit conditions and bank lending rates.

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