The EU summit boosts markets — now they await a second piece of positive news in the form of a new ECB interest rate cut this week.

A month of turbulence in Europe concluded with a summit of European Union leaders. Given that expectations for the meeting were very low, financial markets interpreted the fact that eurozone countries ended up being willing to set aside their differences long enough to agree to apply bailout funds intended for beleagured member nations to address the woes of their banking systems, as a major positive step. “We affirm that it is imperative to break the vicious cycle between banks and sovereigns,” the 17 eurozone members pledged in a summit statement. That declaration immediately brightened the outlook for both Ireland and Spain, whose problems are as much a function of the bank debt that both national governments have had to backstop.

It’s still unclear whether this step will prove to be the elusive “game changer” the world has been awaiting in vain thus far. Regardless, market participants greeted it with a relief rally, most importantly in the bond markets of Spain and Italy, where yields fell to (slightly) more manageable levels from their recent highs.

But an agreement on managing the eurozone’s debt crisis won’t be of immediate assistance in jumpstarting the region’s economy. The apparent success of the summit in avoiding full-fledged panic on the part of investors means, ironically, that the European Central Bank may now have more room to maneuver when it comes to setting interest rate policy at its meeting later this week. Thus far, the ECB has been reluctant to be seen taking on the leadership role that eurozone politicians have tried to duck. Now, however, they may well feel more able to act to address the region’s deteriorating economic fundamentals, which economists believe warrant another reduction in key lending rates.

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As the chart above — this week’s Chart of the Week — illustrates, purchasing managers’ data in eurozone nations is in the doldrums, and recent data points, such as the recent news from German, show it heading lower, rather than higher. As recently as mid-June, most economists thought the ECB would stand pat, and keep key lending rates unchanged for the forseeable future. In a Reuters poll taken before the EU summit, 48 of the 71 analysts surveyed said they believe the ECB will cut rates on Thursday following their meeting on Thursday; most predict rates will fall to 0.75%, and that they’ll stay at this record low level until at least 2014. Historically, the ECB has been very focused on containing inflation and has made policy decisions with one key trained on its inflation target; but as this chart shows, in practice there also has been a reasonably strong relationship between the pace of economic growth and interest rate changes.

The ECB already has taken steps to calm the regional crisis by pumping some 1 trillion euros into struggling banks in the shape of cheap three-year loans. The agreement of summit leaders may not get the ECB off the hook altogether – the details have yet to be finalized, and it’s possible the central bank will need to find ways to provide bridge financing while waiting for this new influx of capital to reach the banks. Still, given the ECB’s clearly-articulated preference to have politicians lead the way and not central bankers, the results of the summit may well make the eurozone central bank more comfortable with being more proactive.

Unsurprisingly, the summit declaration fell short of what some economists have been hoping and calling for: measures that will lead to some form of banking union and, ultimately, fiscal union among eurozone nations. It remains to be seen whether Germany and other holdout nations can be nudged further along that path, or whether policymakers can develop a viable set of alternative policies that will offer a long-term solution to the debt crisis. But the summit’s result has been to lob the ball back into the ECB’s court once more. Look for a return volley at the central bank meeting later this week, possibly in the form of an interest rate cut.

 
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