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How Far Will ECB Go and Could the BoE Pull the Trigger?

Last updated 10/5/2011 4:07 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

By Kathy Lien, Director of Currency Research at GFT

There has been no shortage of volatility in the financial markets this week and the excitement will only increase with tomorrow’s two central bank rate decisions.  The European Central Bank and the Bank of England’s monetary policy committees will be convening to discuss whether more stimulus is necessary.  The recovery in both parts of Europe have hit a brick wall and for the Eurozone in particular, credit default swap spreads are through the roof which means European policymakers need to rush to prevent contagion.  Despite the recent recovery, both the euro and British pound have experienced extensive losses over the past month and the prospect of a recovery or a further sell-off in the euro could hinge on tomorrow’s rate decision.  Unfortunately, the Bank of England is not expected to make any changes, which is why we will discuss the ECB’s options first and how they can potentially impact the euro. 

Will the ECB Go So Far as to Cut Interest Rates?

Aside from the possibility of a major policy change, tomorrow’s rate decision by the ECB will also be Jean-Claude Trichet’s last.   Having served as the head of the central bank for the past 8 years, Trichet’s candor and no-nonsense attitude will be sorely missed.  With this in mind, the central bank has four main options but before delving into their potential impact on the euro, it is important to be aware of the market’s expectations.  Of the 52 economists surveyed by Bloomberg,42 expect rates to remain at 1.50 percent, 4 expect a 25bp rate cut while 6 economists from major banks predict that the ECB will lower interest rates by 50bp.  There is also a general belief that the central bank will take additional measures to ease the strains in the financial markets.  This includes extending the terms of their refinancing operations, restarting their covered bond purchase program and widening their interest rate corridor by cutting the deposit rate. 

Scenario 1:  Abstain from any Policy Changes > Very EUR Bullish

The ECB’s first option is to do nothing at all. This will be Trichet’s final monetary policy meeting and after tomorrow, the fate of the region will be in Mario Draghi’s hands.  If Trichet wants a smooth transition, it may be prudent to abstain from any major policy changes, leaving Draghi with a clean slate to do as he sees fit and build his reputation and credibility in the process.  According to Trichet’s recent comments, price stability remains their main priority and unfortunately inflation is high with the estimate of consumer prices for the Eurozone rising to 3.0 from 2.5 percent in the month of September.  Having sold off sharply against the U.S. dollar over the past month, abstaining from any major changes to monetary policy could trigger a big short squeeze in the euro that drives the currency back above 1.35 against the U.S. dollar.  If Trichet signals the possibility of a rate cut under Draghi, gains in the euro would be more limited but if Trichet were to do and say nothing at all, expect a parabolic move higher in the EUR/USD. The chance of the ECB abstaining from any policy changes is about 15 percent. 

Scenario 2:  Announce Other Measures but Stop Short of Lowering the Main Interest Rate > Marginally EUR Bullish

Given the ongoing uncertainty created with Greece, the volatility in the financial market and deterioration in the Eurozone economy, the ECB cannot necessarily afford to wait another month to ease the strains in the banking sector and the financial markets.  As a result, there is a 70 percent chance that the ECB will announce new liquidity measures but stop short of lowering their main refinancing rate. By reintroducing a 12 month facility, the ECB would get cash into the hands of banks for a longer period of time.  Restarting the covered bond purchase program would offload some of the chunkier elements on bank balance sheets and free up capital for them to lend while cutting the deposit rate would boost lending among banks and deter them from parking their excess funds with the ECB.  Although helpful and to a large degree expected by the markets, these measures are not as bold as a rate cut and is therefore mildly positive for the euro. 

Scenario 3:  Lower Interest Rates and Introduce Other Measures > EUR Bearish

The third scenario is the most controversial.   Cutting interest rates would usher in a new phase of monetary easing and move the ECB away from its inflation mandate.   Inflation remains high and even though slower growth will ease price pressures, to act tomorrow could be considered premature.  Lowering interest rates would be a strong response to slower growth and growing uncertainty in the region and such a big decision should probably be left to an incoming and not outgoing central bank President.  By cutting interest rates on Thursday, Trichet will be laying down expectations for Draghi.  Speculators will quickly wonder whether Trichet’s successor will be able to fill his shoes and the pressure may hamper his overall judgment.  Considering that less than 20 percent of economists expect a rate cut from the ECB, a surprise reduction in rates would probably send the EUR/USD below 1.32. The chance of a rate cut is low - at approximately 15 percent.   

The following table shows how the Eurozone economy has fared since the last monetary policy meeting and as you can see, there have been far more weakness in the region’s economy.

Bank of England Rate Decision (7:00am ET / 12:00 GMT)

Although the Bank of England is not expected to alter monetary policy, based upon recent comments from policymakers, they are certainly warming to the idea.  Multiple Bank of England officials have said they may need to buy more bonds to bolster a faltering economic recovery after holding off adding more stimulus last month in a decision that was “finely balanced.”  However, MPC member Miles said the case for more so-called quantitative easing “has become in my mind quite finely balanced.”  “It wasn’t quite as balanced a decision two or three months back, before we really got the bad news over the summer.”  The bad news came in the form of deterioration in the data of several economic sectors including consumer health, inflation, and manufacturing.   Retail sales turned negative and realized sales deteriorated further.  Consumer confidence also remains depressed at -30 for September.   Inflationary measures are troubling as well with producer prices deflating or flat and consumer prices printing at about 4.5 percent – twice the central bank’s target.  However with manufacturing and service sector activity accelerating and confidence improving there is about a 70 percent chance that the central bank will delay increasing their asset purchase program to November.   If the BoE leaves policy unchanged, the British pound will probably enjoy a minor relief rally because a small group of investors are looking for the BoE to boost asset purchases.  If they follow through with more stimulus, it would be a big surprise to the market and will most likely send the British pound sharply lower.

The following table shows how the U.K. economy has performed since the last monetary policy meeting.    

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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.