Interest rate cut speculation buoys market

Economic activity in the euro zone contracted again last month, prompting speculation that an interest rate cut may be on the cards at next week's European Central Bank governing council meeting.

The prospect of an imminent interest rate cut, and hints that the euro zone's policy of austerity could be softened, buoyed markets, with the European benchmark index closing the highest in eight months, and the bonds of so-called periphery countries, including Ireland, strengthening. Ireland's 10-year bond yield dropped to 3.48 per cent – the lowest since 2006. Two-year yields fell by 15 basis points to 0.844 per cent.

Bond yields
The yield on Italian 10-year government bonds fell below 4 per cent for the first time in almost two and a half years, while yields on Spanish and Portuguese debt dropped to their lowest level since 2010.

The Purchasing Managers' Index for the euro zone – a key economic indicator for the region – showed that private sector activity in all euro zone states continued to contract last month, with Germany experiencing its first drop since November.

The figures came a day after European Commission president José Manuel Barroso suggested that the economic policy of austerity could have reached its limits. At a conference in Brussels, the European Commission chief said that while the policy is "fundamentally right", it had to have political and social support.

“I think it has reached its limits in many aspects, because a policy to be successful not only has to be properly designed. It has to have the minimum of political and social support.” Such measures had to be politically and socially acceptable, he said.

But German officials yesterday distanced themselves from the comments, with German foreign minister Guido Westerwelle saying that renouncing the budget consolidation policy would increase debt and cement unemployment for many years to come. His comments suggest the difficulties that face Germany in sanctioning any easing of the deficit-reduction policies, particularly in an election year.

Any change in economic policy could have an impact on the deficit-reduction targets set by the European Commission for individual member states, as well as those in a bailout programme such as Ireland.

Yesterday’s closely watched PMI figures showed that the index for Germany fell sharply to 48.8 last month, a six-month low. Any reading under 50 indicates economic contraction. The index for the euro zone as a whole remained unchanged at 46.5 in April, indicating continuing economic contraction.

There was some good news from France, where the economic output contracted at a slower pace than the previous months, with the index increasing to 44.2 in April up from 41.9 in March.

Disappointing figures
The disappointing economic output figures for the euro zone emerged as separate data showed weak business activity in China and the US. The flash PMI for the US fell to 52 last month, down from 54.6 in March.

The HSBC Purchasers Managing Index for China suggested that manufacturing growth in China slowed last month, in part due to lower demand for exports as the global economy struggles to recover.

The European Central Bank’s governing council meets next Thursday in Bratislava, amid expectations that a 25 basis point reduction could be sanctioned.

Last month ECB president Mario Draghi said the bank stood "ready to act" if needed, both in terms of "standard" and "non-standard" measures. Though interest rates are at a record low of 0.75 per cent, this is still higher than in other economic blocs. Economists are divided on whether an interest rate cut is imminent. The euro fell to a two-week low against the dollar yesterday.