Tags: EU

E.U. Stocks Slide as ECB Gears Up to Fight Inflation with Higher Rates

By , Money Morning •

By Jennifer Yousfi
Managing Editor

European stocks were gutted yesterday (Thursday) as banks took heavy losses in the face of more hawkish inflation comments from European Central Bank (ECB) President Jean-Claude Trichet that put pressure on already struggling financials.

The Dow Jones Stoxx 600 closed down 2.6% to 288.48, the worst finish for the Eurozone index since October 2005. The FTSEurofirst 300 had a 2.5% drop, to close at 1,197.02 points, its largest one-day percentage drop since mid-March, Reuters reported.

Regional indices faired the same, as the Paris-based CAC40, London's FTSE 100, Madrid's IBEX 35 and the Frankfurt-based DAX all posted declines.

"Overall, there is unprecedented confusion as investors seek to weigh up credit-led deflation against commodity-led inflation – with the unknown factor being how close we are to our commodity/infrastructure constraints to growth," analysts at Credit Suisse Group AG (ADR: CS) said, MarketWatch reported.

Adding to the sell-off was a report from Goldman Sachs Group Inc. (GS) analysts further downgrading the outlook for U.S. financials such as Citigroup Inc. (C).

The specter of higher interest rates and tighter credit markets shook European financial firms that are still struggling due to exposure to the troubled U.S. subprime mortgage market that has led to billions in write-downs at some of the European Union's most well known names.

A $19 billion loss in the first quarter for Swiss bank UBS AG (ADR: UBS) led to the ouster of former Chairman of the Board Marcel Ospel.

More recently, Britain's Barclays PLC (ADR: BCS) announced it would raise $8.9 billion in much-needed capital in order to prop up its weak balance sheet and try to maintain its dividend. Most of the emergency liquidity will be obtained through investments from foreign sovereign wealth funds.

And if a recent report from analysts at the Royal Bank of Scotland Group PLC (ADR: RBS) is correct, the worst is yet to come for global financial firms that have already taken almost $400 billion in write-downs thus far.

RBS analysts have warned clients to brace for a full-blown crash in the global stock-and-bond markets in the next three months, as the conflicting realities of slowing growth and rising inflation paralyze the world's major central banks - causing "all the chickens [to] come home to roost," Great Britain's Daily Telegraph newspaper reported.

But even while Europe's markets staggering and financial firms still looking to regain traction, Eurozone inflation is grabbing the front-page headlines.

Trichet's Tough Talk on E.U. Inflation

Trichet has signaled that the ECB will raise its key interest rate to 4.25% from its current level of 4.0% at its next monetary policy meeting scheduled for July 3. The ECB president has been quick to add that he has no further plans after the initial 25-basis-point hike and will wait to see how inflation plays out over the course of the year.

 "I didn't say that we would envisage a series of increases," Trichet told the European Parliament earlier this week. "I didn't say that. That being said, we never precommit."

While Trichet is playing his cards close to the vest about future monetary policy decisions, the market is already betting on a series of rate hikes.

Eonia (Euro Over Night Index Average) forwards contracts are being priced at 4.5% for December and 4.64% for March, Bloomberg News reported. 

"There is disagreement among ECB policy makers about the future course of monetary policy, but one increase will simply not be enough," Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group PLC (ADR: RBS) in London told Bloomberg. "At the end of the day, inflation concerns will rule."

Year-over-year, the inflation rate was at a 3.7% in May for the 15-nation Eurozone, well above the ECB's preferred target of 2.0%. Trichet has repeatedly said the central bank will act to fight inflation before dangerous secondary effects, such as higher wages, become entrenched in the European economy.

And the banks' "primary mandate" is fighting inflation. Despite some economic softening in various E.U. member countries such as Spain, the ECB is being called upon to prove its hawkish stance is more than just talk.

"It would not be credible for the ECB to hike just the once and then expect inflation to fall back," Robert Robis, a fixed-income portfolio manager at OppenheimerFunds Inc. in New York, which manages $260 billion, told Bloomberg. "It has its hand forced by its own mandate."

If Trichet & Co. don't come through with the rate increase that has been widely alluded to in the press, it's likely that the ECB president will raise a harsh round of criticism, much like his U.S. counterpart, Federal Reserve Chairman Ben S. Bernanke.

Faced with soaring food and energy prices, Bernanke and the other members of the Federal Open Market Committee (FOMC) voted to hold the Federal Funds rate steady at 2.0% on Wednesday, as downside threats to economic growth remain.

"When it comes to inflation, the Fed has clearly shown that it has no stomach for actual combat," Peter Schiff, president of Euro-Pacific Capital Inc., told The New York Post.

"If it did, it would have long ago followed the lead of the ECB and held the line on interest rates," Schiff said in reference to the most aggressive rate campaign in a generation. "In truth, Bernanke simply wants to preserve the expectation that he will act, even if it is the last thing on his mind."

News and Related Story Links: