ECB and BoE Rate Decisions: Scenario Analysis

Last updated 3/4/2009 2:01 PM ET (GMT -5) 0 Comments - Add your comment

Kathy Lien

Director of Currency Research, GFT

The two biggest event risks for currency traders over the next 24 hours are the Bank of England and European Central Bank interest rate decisions. The first up is the BoE, who is expected to cut interest rates by 50bp to 0.5 percent. They will be followed by the ECB, who should match that rate cut by bringing rates down to 1.5 percent. For both central banks, interest rates will hit record lows but the size of the rate cut is less important than what the central banks plan on doing next. Unfortunately despite aggressive easing, easier monetary policy is still needed. If it was mathematically possible, interest rates should be taken to negative levels by all of the major central banks. The focus on Thursday will be on Quantitative Easing, the new catchphrase in the financial markets ( What is Quantitative Easing? ). In the past, there was a lot of stigma surrounding Quantitative Easing, but these days with the Federal Reserve and the Bank of Japan already buying up government securities, the stigma is slipping. The U.K. is expected to officially unveil their Quantitative Easing program, while the Eurozone could hint at it.

With that in mind, let us take a look at the possible outcomes for the upcoming interest rate decisions and how the Euro and British pound could respond.

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

The Bank of England remains one of the most aggressive central banks. Having already reduced interest rates by 475bp since November 2007, the central bank is still moving forward with force. U.K. monetary policy officials agree that the recession will deepen significantly and so far their fiscal and monetary stimulus has yet to work. In the minutes from the previous monetary policy meeting, the members unanimously agreed that central bank Governor King should ask the Chancellor for the authority to start purchasing government securities. In other words, they are seeking the permission to engage in Quantitative Easing. On Tuesday, Chancellor Darling hinted that QE will be approved which would allow the central bank to start to “printing money.” There are 2 uncertainties for tomorrow’s rate decision, the size of the Quantitative Easing program and whether or not the BoE will continue to lower interest rates. Fundamentally, Quantitative Easing is bearish for the British Pound.

Scenario 1: 50bp Rate Cut, QE, No More Cuts

The most likely scenario is for the BoE to cut interest rates by 50bp and announce a Quantitative Easing program that would involve purchasing £100 to £200 Billion government bonds and other securities. If they signal that interest rates have hit rock bottom or fail to mention the possibility of further interest rate cuts, we could actually see the British pound recover after an initial sell-off. A smaller QE program is the less negative for the currency.

Scenario 2: 50bp Rate Cut, QE, Talk of More Rate Cuts

The difference between Scenario 1 and 2 is simply that the Bank of England actually talks about the possibility of more rate cuts, similar to the Bank of Canada’s announcement earlier this week. Although there is only limited room for further easing, the sheer fact that the BoE could be open to it is a reflection of their desperation, which would not only be bearish for the British pound, but it could drive the GBP/USD well below 1.40.

Scenario 3: 75bp Rate Cut or No QE

Scenario 3 is the least likely scenario for tomorrow’s BoE rate decision. If the central bank decides to cut interest, which would be a much larger amount than the market currently expects, the British pound could sell off aggressively. Alternatively if they cut by 50bp but fail to get approval from the Chancellor to engage in Quantitative Easing, which is very unlikely, it would be bullish for the currency.

European Central Bank Rate Decision (7:45am ET or 12:45 GMT)

In contrast to the Bank of England, the European Central Bank has been among the least aggressive central banks. Since September 2008, they have reduced interest rates by only 225bp. Although the region’s economy is also in deep recession, the central bank has been reluctant to ease interest rates aggressively on the fear of future inflationary pressures. The ECB rate decision could have the more significant impact on the currency market because there are a lot of uncertainties. The central bank could ease more or less than expected for a variety of reasons and they could suggest that they are looking into Quantitative Easing. As usual, the ECB rate decision will be followed by a press conference from central bank head Trichet. The press conference which begins at 8:30am ET or 13:30 GMT is oftentimes more market moving than the actual rate announcement.

Scenario 1: 50bp Rate Cut, Hint of QE

After leaving interest rates unchanged in February, the most likely scenario is for the ECB to cut interest rates by 50bp and hint that they are “studying” and not implementing Quantitative Easing. Recent comments from ECB officials have been dovish and Trichet has previously indicated that the market’s expectations for the rate decision are well placed, meaning that a 50bp rate cut is realistic. On Tuesday, ECB member Noyer openly admitted that the central bank is studying the pros and cons of unconventional monetary policies. Should ECB President Trichet confirm this, we could see the EUR/USD make another attempt to break 1.25.

Scenario 2: 50bp Rate Cut, No Talk of QE

Scenario 2 is almost as likely as scenario 1 given Trichet’s stubbornness and obsession with inflation. If he fails to drop any hints about Quantitative Easing or suggest that he is unsure about further rate cuts, we could actually see the Euro rally.

The least likely scenario for the ECB is a 25bp or 75bp rate cut. A move other than a half point cut would be a big surprise for the currency market. The reason why the ECB may opt for a quarter point cut is because they are deathly afraid of inflation pressures. On the other end of the spectrum, a 75bp rate cut is possible because troubles in Eastern Europe could compel the ECB to take some insurance out on the region’s economy by cutting interest rates more aggressively. However, being proactive is not something the ECB is known for in this downturn and therefore a 75bp cut is very unlikely. Should this extreme scenario unfold for whatever reason, a quarter point cut would be EUR/USD bullish while a 75bp cut would be EUR/USD bearish.

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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.