Interest rate decisions are long-time favorite events for currency traders. However, in the past three to six months, these meeting have garnered little more than a sideways glance from most traders. It is true that interest rates are generally at their lowest levels in recent history and most economies are still struggling with their respective recoveries (which subsequently keeps policy officials from moving on interest rates). Yet, the economic recovery is indeed underway and it is only a matter of time before yields follow suit.
In stable markets (like the type we have seen recently), speculation grows extremely sensitive to big-ticket fundamentals. This fact alone may end up generating a lot of heat from Thursday’s European Central Bank (ECB) and Bank of England (BoE) rate decisions. While neither is expected to alter their benchmark rates, their commentary has grown increasingly energetic. The European authority has vowed to keep its benchmark unchanged for the time being; but was the end of the unlimited fund auctions already set the time table for hikes into motion? For the Monetary Policy Committee (MPC) in the UK, economic conditions and forecasts have grown even more dour since the last rate decision. Will this force their hand on the deposit rate?
The ECB
The ECB’s rate decision is actually scheduled for release some 45 minutes after its English counterpart’s (at 11:45 GMT); but it has the more drawn out impact on the markets. The initial announcement has not held any surprises since May when the group last lowered the benchmark lending rate to its currency 1.00 percent. However, the event doesn’t end with a hike / no hike decision. Central bank President Jean Claude Trichet will once again hold his public address 45 minutes after the initial announcement and answer reporters’ questions.
Right off the bat, economists are unanimous in their expectations for rates to be held at its current record low level. Markets expect much the same with Credit Suisse overnight index swaps pricing in no probability of a change. The market will instead have to get its actionable content from the statement and Q&A to follow.
In recent weeks and months, Trichet has been adamant in his warnings that the economic recovery is the primary concern with monetary policy and the target rate will likely be kept at low levels until next year. For speculators that are used to the same warning from across the globe, the real interest is in the timing as to when rates will once again be lifted and how aggressively policy will be tightened from there. Actions speak louder than words and calling an end to the unlimited fund auctions to banks recently is a clear first step at reining in stimulus. There are a few more steps before pre-emptive hikes can be considered; but the positive growth measured in German and France through the second quarter along with Australia’s move to a hawkish stance put the ECB under the magnifying glass as they are expected to be the next likely candidate to take up the inevitable.
The BoE
The Bank of England is the black sheep of the majors. Whereas most of the other G20 economies are already on pace to a certain recovery, the United Kingdom has actually extended its record breaking recession through the second quarter and forecasts for a further rebound have been weighed. Just this past week, we have seen the IMF pass over the economy when delivering upgrades to forecasts and the NIESR GDP Estimate to round out the third quarter reported a stagnant period. Working with a deteriorating growth position, there is no scope for hikes. At the same time, neither can they lower their benchmark (as it would do no good). Economists uniformly predict there the rate will hold at 0.50 percent and the markets are more or less in agreement (interest rate swaps actually price in a small chance of a cut).
Clearly conditions in the UK warrant action from policy officials; but they are running out of rope. Having already lowered the benchmark to near-zero, injecting liquidity into the financial infrastructure and inflated their bond purchasing program to extraordinary levels, the MPC is running out of options. There is a time frame for stoking a recovery and it is quickly coming to a close. If growth does not take a firm hold soon, the side effects of extremely loose monetary policy will balloon and an upcoming government spending cut (expected to be the biggest since the 1970s) will make a reasonably paced recovery that much more difficult to facility.
So, what can officials do? There is are a few options available; but the one that has been most discussed is cutting the deposit rate. This is the rate paid on bank reserves. In the recent past, BoE Governor Mervyn King has suggested such a step could be a “useful supplement,” but it was a meeting last week that squashed the market’s sense of probability with rumors suggesting they were not considering such a move. However, if they feel the economic and financial situation is in dire enough straights, they will certainly exercise this option. Yet, such a move would also catch the market off guard and likely lead to a pound plunge.
Euro and Pound Technical Setup
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>