The disturbing weakness of today?s US economic data has distracted everyone from the second most important event risk this week, which is tomorrow?s European Central Bank interest rate decision. Typically the ECB likes to let the market know at least a month in advance what they plan on doing with interest rates.
This time however, Trichet and company will have traders guessing up to the last second. There are three potential outcomes of this much anticipated rate decision. The first and the most unlikely is if the ECB raises rates to 4.25 percent. This surprisingly hawkish move would be extremely positive for the Euro, taking the currency pair back above 1.3700. The second scenario is for the ECB to leave rates at 4 percent, drop the words strong vigilance and add some other dovish comments that would allude to interest rates remaining unchanged for the remainder of the year. This would be extremely bearish for the Euro, taking it back below 1.3550. The third scenario would be for the ECB to leave interest rates unchanged and make convoluted or slightly hawkish comments (which may or may not include the words strong vigilance and in essence leave the door open for further rate hikes. In this case, the reaction in the Euro should be limited. Given the recent move in European bond yields, the ECB really has no choice but to leave interest rates unchanged. Economic data has been mixed while inflation pressures have been modest. The only area of concern is the financial markets and how much damage US subprime losses may have had on the German banking sector. Expect tomorrow?s rate decision to take the Euro out of its 1.3550 to 1.3680 trading range.
Written by Kathy Lien, Chief Currency Strategist of DailyFX.com