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Financial Stability Review Explains Why the ECB Will Ease More

Posted: Monday, December 7th, 2020

Estimated Reading Time: 2 minutes

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The Financial Stability Review report is one of the most-watched by Euro traders. Released twice a year, it represents a comprehensive analysis of the Euro area economies.

This year, the report is particularly important due to the COVID-19 pandemic and how it affected the Eurozone economies. Because in three days, we will find out the European Central Bank (ECB) last decision in 2020, the report helps explaining why the ECB will further ease the monetary policy conditions.

Financial Stability Review

Financial Stability Review Report Highlights Fragile Economic Recovery

The November 2020 report highlights the fragility of the economic recovery in the Euro area. Further policy support is needed, especially considering the weak profitability prospects of Euro area banks. While well-capitalized, credit losses put pressure on profitability.

Sovereign spreads and risk sentiment were supported by the EU Recovery Fund announced during the summer. However, rising medium-term sovereign debt sustainability risks represent a threat if we only consider Hungary and Poland’s veto to ratify the fund.

Moving forward, the report shows the weakness in the corporate sector and highlights the risk of rising solvency pressures. As such, the ECB cannot and will not remain insensitive this week.

Can the ECB Surprise Markets?

The ECB’s decision in a few days from now is the key event of the week. The central bank did not announce any new measures in October for the simple reason that it waited for the Financial Stability Review report.

With new data at hand, the central bank looks poised to ease financial conditions even more. The market already expects a lot from the ECB, and most of it might already be priced in. However, the ECB can still surprise the market.

An extension of the PEPP and TLTROs is on the table, but no one knows how far the ECB will go. For instance, a consensus exists that the two programs will be extended until mid-2022. Yet, the ECB may under- or over-deliver. Any extension shorter than expectations represents a hawkish perspective for markets, something that the ECB wants to avoid.

The duration of ECB’s policy support is key in Thursday’s message to the markets. During the pandemic, Eurozone households doubled their savings ratios to about 24%. This means a strong consumption pullback, and as long as it holds to such levels, the monetary policy must compensate for it.

As the Financial Stability Report in November shows, the recovery to pre-crisis levels will take longer than initially thought. Therefore, the ECB cannot and will not allow such risks and will act proactively.

The only question is how far the ECB will go this time? If it wants to send a strong signal to financial markets, it needs to go bigger than any market expectations.

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