The ECB and BoE Rate Decisions Can Be Market Moving Without Cuts

The European Central Bank and Bank of England are scheduled to deliver their respective interest rate policies tomorrow at 11:45 and 11:00 GMT respectively. Looking at the consensus forecast among economists, both meetings are expected to end without a shift in either benchmark lending. However, interest rates are the least of fundamental traders’ concerns. Forecasts for growth and market health along with potential changes to quantitative easing efforts will be measured against a buildup in speculation to provide a catalyst for significant potential energy.

The Bank of England: Quantitative Easing[/B]

There is next-to-no chance tomorrow that the Monetary Policy Committee will lower its benchmark lending rate. Indeed at 0.50 percent, they have no room to further loosen the reigns – nor would further easing at this point infer any economic benefit. Does this mean the announcement will provide no market reaction? Absolutely not. The bank has held its benchmark lending rate unchanged at the past three meetings and there has been at least a modest reaction from the British pound after each. On the other hand, compared to the response in price action to actual cuts, the response has certainly ebbed.

Without interest rates to work with, fundamental traders will be looking at the size of the central bank’s asset purchase program and any notable shifts in sentiment in growth and market forecasts. At the last meeting, BoE Governor Mervyn King and his fellow committee members decided to expand their quantitative easing program by 50 billion pounds to 125 billion pounds. It is unlikely that they would step up their plan once again so soon unless conditions deteriorated markedly. As such, the market is likely fully prepared for no change to the rates or the QE bill; and such an outcome will generally offer little in the way of market reaction. A less likely but far more market moving scenario would be for another increase to asset purchase plans which would immediately put pressure on the sterling as market participants doubt the UK’s health and discount the struggle in its recovery.

The European Central Bank: Room to Cut and Just a Toe into QE[/B]

In contrast to the BoE, the European Central Bank has room to both lower their interest rates and expand their unorthodox policy efforts. Despite sharp economic recessions, ballooning budget deficits and even some sovereign credit downgrades for some of its member economies; the central has bank taken a conservative pace to lowering its overnight financing rate and delayed its adoption of quantitative easing. They have done so by holding open access to unlimited pools of liquidity and likely expecting the global recession and financial crisis to ease before their hand was forced.

Clearly, the ECB is at the extreme of the policy spectrum. With a relatively high benchmark and fiscally unburdened government, the bank is positioned well for a recovery in inflation and growth. From a trader’s perspective though, this also means the euro has a lot to lose. The first concern is interest rates. Economists heavily favor no change from 1.00 percent. However, they have lowered the benchmark consistently at the last four meetings. Vocal policy members have shown a clear split in policy approach from here on out. Some have argued rates should go no lower than this one percent level; while others have argued that further easing may be necessary to stimulate growth. This set’s the bias (although very slight) towards a follow up cut. Then why are Credit Suisse overnight index swaps pricing in a 70 percent probability of a 25bp hike? This likely a premium built up through market interests; but it will certainly have to be deflated should the ECB hold (or cut).

Our fundamental concerns don’t stop there. Quantitative easing is another issue. At the last meeting, the ECB President Jean-Claude Trichet and his fellow policy makers decided to move into the unconventional by announcing a 60 billion euro covered bond purchasing plan. However, it was suggested that up that the group considered expanding that budget up to 125 billion euros. This opens the door to opening up the gates further at this meeting. If this is the case, the ECB’s outlook for growth would be considered much worse than what market participants had pegged; and the euro would be put on the chopping block.


In considering what currencies are best to trade on this combined event risk, we have to consider what external factors could be at play and the probable outcome of the two decisions. First of all, exposure to risk appetite will muddy the market’s reaction as a swell or collapse in sentiment could easily dampen or overwhelm a shift in policy. This means that the yen and Swiss franc are poor counterparts. Also, the heavy market-moving potential in Friday’s US NFPs could diminish the impact of the policy decisions in anticipation of a more pressing employment shift. What’s more, both the ECB and BoE are not expected to make significant modifications to policy. Therefore, the best option is a pair that sets these two currencies against each other – EURGBP. There is certainly risk exposure here, but there will more likely be a ‘pure response to these events with this liquid cross.

Looking Beyond Thursday’s Rate Decisions[/B]

Over the past 12 to 18 months, the central banks of the world’s leading industrialized economies have loosened interest rates as a means to bolster economies reeling from recession and stabilizing credit markets that have suffered from a world-wide credit crisis. We are now at the point where the pace of economic contraction is easing; but this is not the same thing as – nor is it necessarily a prelude to – positive growth. Most policy groups the world over have taken the same general course; but there has always been two distinct approaches. On one side, there are those central banks (like the Bank of England and Federal Reserve) lowered their target rates aggressively to stave off a more crippling economic contraction. In contrast, other monetary policy makers (like the European Central Bank and Reserve Bank of Australia) have deferred to a wait-and-see approach where they can to assess the impact of each round of rate decisions. Though these groups are not in the business of speculating, these two contrasting approaches could react very differently depending on how conditions evolve going forward.

For those that have loosened their lending rates to near zero and moved on to quantitative easing, the downside is that should growth return; it will be difficult to absorb the liquidity pumped into the market (a possibility that German Chancellor Angela Merkel voiced this week) and the rebound could produce new problems (like hyperinflation). At the same time, should economic activity struggle going forward, those groups that were more aggressive will have be in a better position to handle the crisis.

More noticeable given the rise in risk appetite recently and the currencies that benefit this shift in sentiment, the central banks that were more frugal in doling out aid will have less of a liquidity hole to dig themselves out of. What’s more, the premium in their rates will encourage capital flows that should bolster a recovery. Alternatively, a second round to the global recession will require an accelerated response through policy that will in turn trigger a sharp depreciation in the relevant currency.

Written by: John Kicklighter, Currency Strategist for
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