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How the ECB Meeting Could be a No Win for Euro

Last updated 11/2/2011 8:57 AM ET (GMT -5) 2 Comments

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Kathy Lien

Director of Currency Research, GFT

Thursday’s European Central Bank announcement will be monumental for 2 reasons.  It will be the first time in 8 years that the meeting will be chaired by someone other than Trichet. It will also be a meeting where the ECB either cuts interest rates or signals plans to do so for the first time in more than 2 years. Over the past month, financial and economic conditions in the Eurozone have taken a turn for the worse – based upon the latest PMI numbers which show contraction in the service and manufacturing sectors, the region’s economy is headed for recession. Rising borrowing costs and fiscal austerity will put additional pressure on growth, making recession not only possible but probable. It will be a baptism of fire for Mario Draghi, the new ECB President who will be inheriting a region deep in crisis. Removing the 50bp of tightening by Trichet earlier this year is not only needed but would be a sign that the new ECB head will be tackling the crisis head on in a decisive and aggressive manner.   If Draghi lowers interest rates at his first ever monetary policy meeting, he will be digging a knife into the heart of the euro even if it the bitter medicine that the region requires.  If rates are held steady but Draghi signals plans to cut in December, the euro could still suffer but the sell-off would not be as sharp.  Either way, the ECB monetary policy announcement will most likely be a no-win situation for the euro. One of the main arguments for holding off till December aside from being able to offer investors an early holiday present is the fact that new staff forecasts will be available for that meeting, giving Draghi the evidence he needs to justify a rate cut but with equities and currencies under pressure, he may not be able to wait. 

Aside from interest rates, Draghi will also be grilled about his willingness to involve the central bank in any secondary bond market purchases. Last month, Draghi appeared willing to intervene in the debt markets by buying the bonds of troubled Eurozone nations, an issue so contentious that it has led to the resignation of some ECB members. Trichet said earlier this week that Draghi’s readiness to buy bonds was misinterpreted and he will be under pressure by reporters to clarify his stance on Thursday.  

What Do We Know About Mario Draghi?

The former President of the Bank of Italy and an American-trained economist with a background in both the public and private sector comes with a tremendous amount of experience and is said to be able to command the same respect as his predecessor from central bankers and policymakers around the world.   He is oftentimes considered a thoughtful participant who is particularly skillful at guiding groups towards an agreement and this skill will be extremely valuable in his new role. Trichet has been known for his public clashes with politicians and given his reputation Draghi may be more conciliatory which could mean more openness towards the ECB’s involvement in the EU’s rescue plans. Draghi also comes off far less passionate than Trichet in public suggesting that he could also be less direct and more careful in signaling potential changes to monetary policy. This is a characteristic of Trichet that we will miss dearly and we will find out quickly whether Draghi shares the same personality traits at his first monetary policy press conference tomorrow. His greatest challenge aside from stabilizing investor confidence is to learn how to properly communicate to the market, something his predecessor has been particularly good at.

The new central bank President will be jumping head first into the Eurozone crisis. Aside from adhering to their inflation mandate, Draghi will need to carefully consider the calls for more ECB involvement that have received quite a bit of internal criticism. Jurgen Stark submitted his resignation last month citing personal reasons that many have attributed to his concern about the ECB’s increased responsibilities. Three of the board’s other six executive members are either new or getting ready to leave which could pose an additional challenge for Draghi who needs to take bold measures tackle the region’s sovereign debt crisis and slow growth. It is difficult to tell if Draghi’s views differ all that much from Trichet’s because in recent months he has kept a low profile and has taken care to align himself with Trichet’s views with the hopes of either minimizing volatility at a sensitive time in the markets or paving the way for a smooth transition. In the past, he has been considered a monetary policy hawk but shortly after his nomination was made public, Draghi vowed to pursue a policy of gradualism in raising interest rates and rolling back emergency liquidity measures. However policy normalization is not what worries investors at this time. Instead, the biggest question on everyone’s minds is whether Draghi will usher in a new wave of rate cuts to promote growth and allow for greater ECB involvement in the European Union’s rescue plans. Mario’s Draghi’s first few comments as ECB President will be the most important and potentially the most market moving. 

Checking in on the Eurozone Economy

The following table shows how the EZ/German economy has performed since the last monetary policy meeting. A closer look at the economic releases reveals more deterioration than improvement in the economy. Inflation readings have lagged since the last meeting, while the health of the consumer has picked up. Germany has been hit especially hard. German flash manufacturing PMI has crossed below the 50 line to 48.9 in October indicating contraction. The index was barely in expansionary territory back in September at 50.3. German industrial production fell sharply in August, printing at minus 1.0 percent from an increase of 4.0 percent in July. The most significant deterioration can be seen in the German ZEW survey, which fell to 38.4 in October from 43.6 a month prior. Investors have a very pessimistic outlook for the next 6 months in Germany due to Greece’s uncertainty and slowing global growth and the deterioration in the labor market certainly doesn’t help. However, Germany’s consumers are better off this month as retail sales rebounded into positive territory. Retail sales increased 0.4 percent in September compared to a decline of 2.7 percent in August. The German consumer climate has also slightly improved, printing 5.3 for October following 5.2 for September. The German DAX index has risen 4.5 percent since the last monetary policy meeting but 10 year bond yields are lower. Broader Eurozone economic measures have shown continued weakness as the ECB prepares to meet tomorrow. The EZ manufacturing, services, and composite purchasing managers’ indices all declined in October, having already been in a state of contraction in September. With Eurozone economic data showing the region flirting with contraction, the ECB will need to take further action to prevent additional deterioration.

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Comments (2)

FXTC

November 02, 2011 at 06:18 PM ET

You could be ecb head just as good. Playing with rates an inch.

InvTraKS

November 03, 2011 at 10:21 AM ET

Not sure how far would eur will tank. Yesterday low? or the daily Fi 61% :)
invtraks.blogspot.com

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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.