ECB, The Reluctant Interest Rate Hawk?

By: Axel_Merk

The European Central Bank (ECB) kept its main refinancing rate unchanged at 1%, but announced that it will phase out its six-month and one-year refinancing facilities and move to an index-based interest rate rather than a fixed or auction based rate for future refinancing operations.

The first move, the phasing out of the long-term refinancing facilities (the last one-year operation takes place this month; the last six-month operation in March) is a very healthy step in normalizing central bank policy. It's also a rather hawkish step as it forces financial institutions to re-finance long-term obligations in the market where rates are higher. Just as in recent speeches, ECB President Trichet urged banks to take advantage of both market conditions and any government support programs to raise capital to improve their balance sheets. In our assessments, the phasing out of the longer-term refinancing facilities put substance behind this urging as it forces European banks - that have generally lagged U.S. banks in raising capital - to clean up their balance sheets.

It seems that Trichet is discussing the euro's strength in more detail with each press conference he holds. Our interpretation of the press conference is that the ECB has initiated its exit strategy in earnest, but is rather concerned it could lead to a substantially stronger euro, especially versus the U.S. dollar. As a result, Trichet bent over backwards in communicating that the ECB is not signaling a rate hike. As to the timing of future rate hikes, Trichet would only commit to say the ECB will raise rates when appropriate.

Some members of the ECB governing council clearly wanted to go further as the ECB changes the terms of the refinancing terms from a fixed rate to one pegged to an index. Except that this peg may be meaningless unless the ECB actually raises rates. In our view, this shows that the ECB may be a reluctant hawk: they want to and will tighten, but are hoping that their hawkishness won't be reflected in the exchange rate.

With these steps, the ECB is light years ahead of the U.S. Federal Reserve (Fed) when it comes to an unwinding of the extra-ordinary support programs; the Fed continues to engage in fiscal policy with its credit easing while piling up securities on its balance sheet that cannot be easily "phased out", but may remain with them for years. The Fed has phased out many emergency programs, but continues to build up its mortgage-backed security (MBS) purchases; by allocating money to a specific sector of the economy, the Fed engages in fiscal policy. It is no coincidence that the ECB portrays an aura of normalcy, whereas Bernanke is on Capitol Hill yet again being attacked about the Fed's policies.

We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

By Axel Merk

Chief Investment Officer and Manager of the Merk Hard and Asian Currency Funds, www.merkfund.com

Mr. Merk predicted the credit crisis early. As early as 2003 , he outlined the looming battle of inflationary and deflationary forces. In 2005 , Mr. Merk predicted Ben Bernanke would succeed Greenspan as Federal Reserve Chairman months before his nomination. In early 2007 , Mr. Merk warned volatility would surge and cause a painful global credit contraction affecting all asset classes. In the fall of 2007 , he was an early critic of inefficient government reaction to the credit crisis. In 2008 , Mr. Merk was one of the first to urge the recapitalization of financial institutions. Mr. Merk typically puts his money where his mouth is. He became a global investor in the 1990s when diversification within the U.S. became less effective; as of 2000, he has shifted towards a more macro-oriented investment approach with substantial cash and precious metals holdings.

© 2009 Merk Investments® LLC

The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds owns and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard and Asian Currency Funds. Foreside Fund Services, LLC, distributor.

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