The ECB cut holds up where it counts

The ECB’s rate cut is supporting a lower exchange rate, and may help eurozone companies recover some latent earning potential.

Lower interest rates and loose monetary policy stances have proved to be positive for equity markets. The recent interest rate cut by the European Central Bank adds even greater support for this theory.

In brief, the ECB decision to cut the main interest rate suggests it doesn’t want to jeopardise the recovery of the eurozone, which has just begun to gain some traction and investor interest.

ECB president Mario Draghi famously said he would do ‘whatever it takes’ to save the eurozone and the latest rate cut decision suggests he is holding true to his earlier words… although it is arguable Draghi hasn’t really been tested. Yet.  

As with other major currencies traded against the US dollar, the euro had strengthened significantly against the US dollar, which dramatically picked up the pace after the Federal Reserve’s decision not to taper. But since the rate cut the euro has lost some ground against the US dollar.

A lower exchange rate should help the overall competitiveness of export-oriented countries within the eurozone. Accordingly it is perfectly plausible to assume lower inflation expectations could be driven by the stronger euro against the US dollar.

And while the interest rate cut surprised many and sent the main European index immediately lower, the reality is European companies still have earnings rebound potential. At the moment, it has been estimated earnings of European companies are still some 30 per lower than 2008 levels, while global earnings per share are back to previous peaks.

Since the ECB cut its benchmark interest rate, we have seen a steepening yield curve for some European countries. While keeping interest rates low in the immediate future is helpful, longer term yields have been rising.

Longer term dated bonds are susceptible to movements in other interest rate markets. The current interest rate environment suggests euro long-term rates are going to be pulled higher as yields on the US Treasury climb once the Federal Reserve begins tapering (or even talking about it).

Movements in the currency market and interest rates ultimately play out to affecting equities in some way. Generally speaking a steepening yield curve is positive for cyclical stocks and often for pure value investors.

Meanwhile, lower interest rates align ECB president Mario Draghi with the Federal Reserve, which continues to deliver monetary support to help bolster the economy. The interest rate for the currency block is now 0.25 per cent, mirroring the benchmark interest rate in the US.

A prolonged period of low inflation is feared by the monetary union, and this justifies its move.

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