Impact of ECB and BoE Rate Decisions on EUR/GBP

Last updated 2/4/2009 5:50 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

Over the next 24 hours, the Bank of England and the European Central Bank will be making interest rate announcements. The Bank of England is the only central bank expected to cut interest rates, but that does not mean that the Euro stay stationary. In fact, we expect some big action in both currencies, which could lead to more volatility for EUR/GBP.

For both central banks, the amount of easing is less important than their comments on how much further interest rates will fall. The upcoming rate cut is not expected to be the last for the Bank of England and the expectation of further rate cuts could prevent a major recovery in the British pound. As for the Euro, dovish comments from Trichet could the EUR/USD to fresh year to date lows.

Bank of England: Headed to ZIRP?

The question that the market will be looking for the answer to from the Bank of England on Thursday is whether interest rates are headed to US levels. The Bank of England and the UK government as a whole has thrown everything including the kitchen sink at their economy and so far, they have nothing to show for it. Since the BoE still has room to cut interest rates, they are fully expected to utilize this monetary policy instrument. A 50bp rate cut would take UK interest rates down to 1 percent, the lowest level ever for the central bank. Since September of 2008, the BoE has had no reservations about taking interest rates from 5 percent to 1.50 percent. The next interest rate cut will bring UK rates closer to zero, which will leave many people wondering, What Next? The BoE is already operating in unchartered territory. Will they start talking about quantitative or credit easing after their monetary policy decision? If so, it would be pound bearish.

Despite restricted economic conditions, there are signs of stabilization. Retail sales, service, manufacturing and construction sector PMI have all improved, but GDP, consumer prices and consumer confidence continue to wane. The UK is also a very financial services centric economy and therefore it may be some time before we see a full blown recovery. While rate cuts may continue into March, they could get smaller and smaller. Comments about the size of the rate could also impact the British pound.

While the urgency and brevity the BoE has acted is undeniable, the effects of their efforts do not seem too reassuring. Problem number one for the UK going forward is the fact that mortgage and other lending rates have resisted the downward pressures. This resistance severely reduces any positive effect the rate cuts were supposed to have on the economy. Without the ability to obtain credit, business and consumers alike will continue to postpone investments and spending until financing becomes available. This unfortunate clash of interests is what will keep the UK in a recession. Efforts have continued over the last month to provide lending institutions with the security required to restore normal credit conditions. In addition to securing and guaranteeing balance sheet items, the government has successfully negotiated the reduced ability of banks to raise their interest rate on loans. This month finally produced some reassuring reports in the form of Mortgage Approvals and Net Lending. However, the threat that credit markets pose has by no means alleviated. It has been shown that any increase in loans is in the form of very small debt obligations. Therefore, the BoE’s focus will have to be entirely on restoring the confidence among banks. While rate cuts are a very likely possibility, their success is doubtful. It is possible that the central bank may have to continue purchasing troubled assets and other toxic securities that are currently plaguing the financial system. This may be the defining factor of continued BoE policies.

European Central Bank: Dovish Comments from Trichet?

After cutting interest rates by 225bp, the European Central Bank is expected to leave interest rates unchanged at 2 percent on Thursday. The prospect of a monetary meeting that leaves rates alone seems almost abnormal these days. We have gotten so used to these massive all-out efforts to see rates go to zero that the idea of no cut may be psychologically worrisome to some traders. The fact of the matter is Trichet has not been quiet about his preference to keep rates remain steady. The ECB President feels obligated to allow the latest string of action time to work its way through the economy. However, up until now, the concerns over a worsening economic environment has not permitted the ECB head the privilege of time. It is undeniable that economic conditions since the last meeting have not made any discernable efforts at improving. However, there are certain bright spots that may allow Trichet the breathing room to resist further cuts. This month has seen, along with some truly devastating figures, a pickup in German IFO, German ZEW, and the Euro-Zone PMI composite.

After the last monetary policy decision in January, ECB President Trichet signaled to the market that 3 weeks is too short of a time to deliver another rate cut and March will be the next meaningful meeting. Unlike other central banks, the ECB has not been extremely aggressive with easing monetary policy and has instead tried to defer rate cuts as much as possible. Even though interest rates in the Eurozone are already at historically low levels, Trichet is still expected to cut interest rates further. The rate decision itself should be a nonevent which leaves Trichet’s post meeting press conference as the main focus. Traders will be looking for clues on how aggressive the ECB will be in March.

Concerns over economic growth still dominate in individual European countries. Despite the fact that some data surprised to the upside they are only small advances off of multi-year lows. Among the reports that may warrant a bit more concern is the severe shifts in EZ and German Unemployment. Even though Trichet has expressed the notion that the risks of deflation are negligible at this point, the overwhelming decline in CPI is significant and he may be forced to address change in price pressures at the press conference. Any acknowledgement of softer pressures could be enough for traders to start pricing in the possibility of 1 percent interest rates in the Eurozone.

Impact on EUR/GBP

With the BoE and ECB rate decisions on tap, one of the currency pairs that could see biggest volatility is EUR/GBP. The currency pair is already trading in the sell zone, which we determine using Bollinger Bands. Support is at 0.8755, which is the 50% Fibonacci retracement of the October to December rally. On the topside, the 0.9090 level could prove to be stiff resistance as we have the confluence of the 50-day SMA and the 38.2% Fibonacci retracement.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.