Forex Trading

The European Central Bank is scheduled to deliver its vote on monetary policy tomorrow; and the market is a little more interested in the outcome of this particular meeting than usual. Forecasts from economists and traders are in agreement as far as the immediate change in the benchmark lending rate. The consensus among economists (tallied by Bloomberg) is unanimous for a 25 basis point rate cut that would bring the main rate to 1.00 percent. Straying little from the path, the market is pricing in a slightly more than a 100 percent probability for an equivalent cut. However, this headline change was never the point of contention.

Where the Conflict Arises

An ongoing recession and lingering problems with financial conditions (along with the political pressures that come along with it) make an additional rate cut the natural choice. However, with tentative signs of a recovery in the making (at this point it is a slowdown in the economic contraction rather than a return to growth) and the financial markets enjoying months of stability; the needs for monetary policy beyond May have taken very divergent paths. In the past, the European policy authority has been hailed for its transparency and projecting the group’s intentions for the future. Through recent months though, central bank members have generated more confusion than they have clarity. Some (including Germany’s Weber) have supported a hold for easing at one percent while playing down the possibility of quantitative easing and other un-orthodox policy approaches. On the other hand, there have been those that have taken the line that the door should be left open for additional cuts and atypical efforts that have already been adopted by the Federal Reserve and Bank of England. Should the ECB take the same tack as so many of its major counterparts, it would be considered by the currency market an admission that conditions are perhaps worse than speculators are expecting and the recovery in the Euro Zone could be stunted due to all the policy that has been put in place.

What are the Scenarios?

There is a lot at stake for this central bank decision; and there are many small factors that can alter the market’s ultimate perception of the results. However, there will be a few specific themes that will be considered critical to the event. First and foremost, the market will look to the unambiguous rate decision at 11:45 GMT. The statement that accompanies the announcement on the refinancing rate is real driver. Any official announcements for changes in the deposit facility, plans to purchase private debt or potentially even the adoption of a quantitative easing-like effort will be presented to the market here. Then there is the ECB President and Vice President’s press conference with reporters at 12:30 GMT. President Jean-Claude Trichet will give more color on what to expect from the future for growth and policy as the public grills him.

This is a relatively simplistic breakdown. There are many nuances to this event and the market’s reaction under the various outcomes is highly uncertainty. At the same time, it helps to gauge what the broader market is preparing for in order to better prepare for an in-line or surprise response. So, to offer some benchmarks, let’s look over some of the potential scenarios and their probabilities.

1. The ECB Cuts by 25 basis points and does writes off neither further cuts nor un-conventional policy (65%)

This is by far the most likely outcome for this meeting. It has been the central bank’s stance since its inception to take slow and measured steps toward its policy. This helps to avoid market volatility and is somewhat necessary in applying policy that impacts many individual economies. At the same time, there are some points of nuance that can arise in the details. Extending loan maturities (something that was expected but not fulfilled last month) and the language surrounding future paths can spark volatility on their own. Status quo (no change to loan maturities or clear signal for a floor underneath rate cuts) could be a driver on its own.

2. The ECB Cuts by 25 basis points and indicates that it is shifting to a wait-and-see stance (20%)

Just a few months ago, the ECB defied expectations after signaling the group would hold off on any further rate cuts or policy shifts at the following meeting to see how previous efforts have impacted the economy and markets (when many other central banks were scrambling for options in addition to whatever easing they could afford). With a benchmark at one percent, there is little additional aid further cuts could afford. What’s more, recent signs of stability could negate the need to expand the money supply (or at least offer more time to assess the situation). Under this scenario, we will look for language that clearly states that there is no cut due in June nor are any additional measures outside of the norm necessary.

3. The ECB Cuts by 25 basis points and makes a definitive shift towards un-orthodox measures (15%)

There is little doubt that the central bank will lower its benchmark by 25 basis points; but does the European economy need additional help to prevent deeper recession? This is the outcome should the answer to this question be ‘yes.’ A rate cut will be followed by language that leaves the door open to further cuts (more inflammatory would be rhetoric that suggests it is necessary). Going one step further would be to admit that further effort must be made outside the normal channels. Least surprising would be an extension of loans. Then, there is the chance that they will take up the purchases of private debt. Most unlikely is announcing outright quantitative easing.

4. Other (5%)

This is the catchall category of those possibilities that are considered very unlikely. A cut that is greater than 25 basis points, no cut at all, or the adoption of many unorthodox tool as once have low probabilities. Of course, if they happen, the response from the currency market would be tremendous.

What Currency Pairs To Watch

EURGBP

This pair is on the cusp of a major breakout. Earlier this week, a rising trend that fought the receding highs was taken out to remove any semblance of a bullish bias. Now, we are left with a wedge formation that yearns for a breakout regardless of the direction. From a fundamental stand point, the euro is still significantly more valuable than the economical battered pound. Should the ECB take a more active role in policy, it could bring the Euro Zone down to the level of the UK.

EURUSD

The world’s most liquid currency pair, EURUSD also happens to be a key gauge for risk appetite. This means that the Euro Zone’s pace of monetary policy could be disrupted by the Fed Stress Test results that are due later in the US session on the same day. However, the technicals are appealing. On Monday, a long-term falling trend was cleared; and now spot is treating that break level as support. The bullish sentiment will have to be significant for EURUSD to run the 200-day SMA rather than reverse.

EURCHF

EURCHF presents another clear wedge that demands a breakout. There are outside factors working against this pair. The Swiss National Bank has stated its plans of FX intervention to prevent further appreciation of the franc multiple times. On the other hand, the two economies are closely tied and policy made by the ECB is often mirrored by the SNB. This could be a complicated reaction.

Written by John Kicklighter, Currency Strategist
Article Source - How Will The Euro Respond To The ECB Rate Decision?