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You can never underestimate the hawkishness of the ECB.  This morning, the central bank cut interest rates by 25bp to 1.25 percent, driving the EUR/USD sharply higher following the smaller than expected move. Here are 3 reasons why the ECB cut by 25bp instead of 50:

Why Did the ECB Cut by 25bp Instead of 50bp?

1. To Maintain Rate Corridor (Difference Between Deposit and Fixed Rate)

2. Give Themselves Room to Cut Again in May

3. 6 Month and 12 Month Money Market Rates are Below U.S. Levels

Based upon ECB President Trichet's comments at the post meeting press conference, the decision to make the smaller cut was aimed at buying themselves time before delivering a game changing announcement next month.  Trichet was crystal clear that 1.25 percent will not be the "low" for interest rates and that future rate cuts will be "measured" which means small. In later comments he added that 25bp is considered a "measured move"  Also, in May, the central bank will decide if nonstandard measures like Quantitative Easing is necessary and if so, they will reveal the "FULL" details on what they plan to do.  The ECB basically delayed nonstandard measures like Quantitative Easing for another month but suggested that they will eventually follow the path of the Federal Reserve and the Bank of England.

Trichet also went to great lengths to describe how the ECB's efforts and commitments are comparable to the Fed.  He pointed out that 6 to 12 month money market rates are below U.S. levels and that the measures they have taken thus far represent a larger portion of GDP than Fed, but of course the Fed is in the process of doing more.  The deposit rate is now at a record low of 0.25 percent.

The decision was not unanimous but reached by consensus. The bottom line is that the central bank wants to maintain the rate corridor which is the difference between the deposit rate (0.25%) and the fixed rate (1.25%). Given that he said the deposit rate will not change from here but he does not exclude "narrowing" the rate corridor, this leaves only one option which is to cut the fixed rate.  

As for the economy and inflation, the outlook remains grim.  Unlike other countries who have been experiencing higher inflationary pressures recently, Trichet warned that inflation could be negative mid-year but should increase again towards the year end.  The short term drop will not be relevant to monetary policy and only means that the Eurozone is in disinflation and not deflation mode. The economy will remain weak in 2009 but could gradually recover in 2010.

May 7th Rate Decision

The positive impact of today's rate decision on the EUR/USD should be limited by the expectation that Eurozone rates will eventually reach the 1 percent level in May and that nonstandard measures like Quantitative Easing will begin then.  It is important for currency traders to realize that all the ECB has done today is to delay the inevitable and that is a Euro bearish and not bullish because it postpones further relief for the Eurozone economy.  However at the same time it is important to recognize that the rally in the euro represents position adjustments as many traders discounted a 50bp move.

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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.