The ECB Has Just Admitted It Is Ready to Tighten Monetary Policy

 | Jun 07, 2017 | 9:00 AM EDT
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Actions speak louder than words, and the European Central Bank (ECB) has just acted in a way that suggests monetary policy tightening is not too far in the future.

When you are a central bank, the trouble with being both the regulator and the lender of last resort for your banks is that your communication policy becomes very complicated. This is exactly the problem the ECB is facing now, after it essentially ordered the sale of "failing, or likely to fail" Spanish Banco Popular  (BPESY) to Santander (SAN) .

Santander's shares fell 3% at the open in Europe, a sign that investors do not like the merger even if the sale price is a symbolic €1.0. Santander will raise €7.0 billion ($7.9 billion) in capital to finance the deal, as it would need to take over Banco Popular's bad debts as well.

This announcement puts an end to weeks of speculation about the fate of Banco Popular, which was Spain's fifth-largest bank by assets, according to rankings by The Banker magazine.

For the merger to be a success, net interest margins -- one of the main sources of profit for banks, representing the difference between what a bank charges on loans and what it pays on deposits -- need to increase. Lending money at a profit is how banks make a living.

Many of the eurozone's banks have been crippled by the ECB's negative interest rates on commercial bank deposits and by its bond purchases, which have driven down yields across the fixed-income universe.

If shareholders are to be persuaded to cough up even more funds for such rescue operations as the one just agreed by Santander, banks will need to become more profitable. The surest way for them to do so will be the ability to charge more for the money they lend, and this cannot be achieved unless interest rates rise.

The question is whether the ECB will consider today's action enough of a signal for markets or whether it will follow up on it with stronger hints at tightening tomorrow, when it holds its monetary policy meeting in Tallinn, the capital of Estonia.

It is unlikely that the ECB will make a major, clear announcement about the end of quantitative easing (QE), but investors should watch carefully for any change in the central bank's forward guidance.

For example, the Governing Council might see the risks to the growth outlook as "broadly balanced" for the first time since August 2011, according to Societe Generale analyst Anatoli Annenkov.

The latest ECB statement from the April 27 meeting said: "The risks surrounding the euro area growth outlook, while moving towards a more balanced configuration, are still tilted to the downside and relate predominantly to global factors."

Investors also should watch the ECB's updated forecasts on economic growth and on inflation tomorrow. It is likely that any adjustments would be small, but the direction matters.

One of the constant headaches for the bank has been that inflation has been below the 2% target for so long. So, the inflation forecast is the more important of the two forecasts. If it is raised, prepare for faster monetary tightening than if it is kept unchanged.

"To us, all of this suggests that June's meeting is the time for the Bank to change its guidance," Jack Allen, European economist at Capital Economics, wrote in recent research. Allen said he believes the ECB's governing council statement will drop the references to "lower levels" of interest rates and to increasing QE if the outlook becomes less favorable.

But investors should not be spooked by changes in the ECB's wording. It is very likely that Mario Draghi, the head of the central bank, strongly will hint that any changes would be gradual, reinforcing his dovish stance.

Besides, the eurozone economy is much stronger now and companies in Europe are healthier. With earnings season finished, data quoted by Oxford Economics show that earnings in Europe climbed by around 35% year on year in the first quarter versus a 15% increase for U.S. companies' earnings.

Indeed, Gaurav Saroliya, an analyst with Oxford Economics, notes that a major reason why European stocks have underperformed peers in developed markets in recent years has been the weakness in the continent's banks; that weakness is tied to the decline in yields.

"The ECB's tapering of QE should go some way towards alleviating this underperformance," he said. With today's decision on Spanish banks, the ECB may have taken a first step in that direction.

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