How Will the ECB and BoE Rate Decisions Affect the Euro and British Pound?

[B]DEC 6[/B]
[B]Bank of England Decision (12:00 GMT; 07:00 EST)[/B]
[B]European Central Bank Decision (12:45 GMT; 07:45 EST)[/B]
[B][/B]
[B]Expected: No Change, 5.75%[/B]
[B]Expected: No Change, 4.00%[/B]

[B]What Are The Markets Facing? [/B]

On Thursday, two major central bank decisions are scheduled to be released, and the results could have a large impact on the markets, particularly in FX. The Bank of England is forecasted to leave rates steady at 5.75 percent, though they are considered to have a dovish bias after two monetary policy committee members voted for a rate cut last month. Meanwhile, the European Central Bank is also forecasted to leave rates steady at 4.00 percent, but they are perceived as holding a hawkish bias, as recent inflation estimates show CPI rocketing above the bank’s 2.0 percent ceiling to 3.0 percent in November. First, let’s take a look at what these two banks have in common: the global credit crunch that has rocked the markets since August has led European and UK interbank lending rates (Libor) to jump to multi-year highs while equity markets remain especially jittery and prone to declines. This has left both the BOE and ECB uneasy, as the instability of the markets adds to mounting downside risks to growth.

Now let’s differentiate. The BOE is still taking flak for the bank run on Northern Rock in September, while housing data has started to falter quite a bit with the most recent readings – the HBOS index – showing prices falling at the fastest pace in nearly five years, while consumer confidence and spending have wanted. Though CPI was stronger than expected in October at 2.1 percent and will likely be even hotter in November, they are forecasted to fall back in early 2008. As a result, there is a chance that a majority of the MPC members will vote for a cut in order to “get ahead of the curve,” as Blanchflower called for recently. Also, traders should watch for a surprise release of a policy statement, like they did in August. Though they do not typically issue these, many central banks have recently moved towards becoming more “transparent” – like the RBA on Tuesday – and the BOE could follow the trend as well.

The ECB, on the other hand, is dealing with rampant consumer price growth while economic conditions remained fairly resilient in Q3 and early Q4. Indeed, the unemployment rate for the Euro-zone fell to a record low of 7.2 percent in October, which may help to support consumer sentiment and thus, spending, going forward. Also faring well was the manufacturing sector, with PMI improving to 52.8 from 51.5. However, the deal-breaker for rate expectations is whether or not Trichet will remain hawkish in his subsequent policy statement: If the ECB President notes the phrase “strong vigilance,” traders may immediately start betting on a hike in January, as this has previously served as an excellent signal of impending policy action. Conversely, if the policy statement focuses more on the downside risks to growth, the markets judge that Trichet’s monetary policy tightening cycle is done for good.

[B]Bonds – 10-Year German Bund Futures[/B]

Bunds have continued to climb, keeping the uptrend intact, as trendline support looms below at 114.63. Risk aversion has kept the contract elevated, but the ECB’s decision could shake them up quite a bit. Hawkish rhetoric by Trichet could propel Bunds towards resistance at the November 26 high of 115.83. On the other hand, signs he is more concerned about financial market instability and downside risks to growth than upside inflation risks could push them down towards trendline support.


[B]FX – EUR/GBP[/B]

The EUR/GBP pair has climbed steadily over the past few months, as the European Central Bank has remained unabashedly hawkish with CPI remaining hot, while the Bank of England has shown some hesitance to take rates any higher as the credit markets tighten further and the housing sector looks prone to slowing dramatically. On Thursday, this pair may be the best option for FX traders looking to play the event risk from the ECB and BOE rate decisions. The most likely scenario is that EURGBP will rally towards the May 2003 high of 0.7253, as hawkish rhetoric from ECB President Trichet will look especially bullish against the potential for either a rate cut by the BOE, or a surprise BOE policy statement that reflects a dovish bias. On the other hand, the pair could falter if the BOE does not cut rates and does not issue a policy statement, as dismal UK data has led speculation of more accommodative monetary policy to mount. Furthermore, if the ECB’s Trichet focuses more on financial market instability and downside risks to growth rather than inflation, weakness in the Euro against many of the majors – including the British Pound – may ensue.


Equities – FTSE 100 Index

On Wednesday, the FTSE 100 rallied towards resistance at the 200 SMA at 6,420 and the 61.8 percent retracements level of the decline from 6,723.70 – 6,026.90 at 6,457. The impetus? Ramped up rate cut expectations for the BOE, as UK economic data proved disappointing while credit market conditions continue to look tight. If the BOE does indeed cut rates, or issues a surprise policy statement containing a dovish bias, the FTSE 100 could break through resistance to target 6,550. On the other hand, the lack of a rate could send the index plummeting towards support at 6,293, with sharper declines taking on 6,191, as traders will be disappointed by the lack of aid to the markets.