ECB Rate Decision (11:45 GMT)
ECB?s Trichet Speaks To Press (12:30 GMT)
Expected: 4.00%
Previous: 3.75%
How Will The Markets React?
Though there are a number of rate decisions scheduled this week (each harboring considerable speculation behind possible hikes), only the European Central Bank?s meeting is looking at another 25 basis point boost with near certainty among traders. The policy group, headed by Jean Claude Trichet, is expected to lift the overnight lending rate to 4.00 percent - the highest the benchmark has been since August of 2001. This move has been priced into short-term interest rate futures since President Trichet revived his call for strong vigilance? in regards to inflation. In the past year, this infamous phrase has evolved into a virtual guarantee for a rate hike at the following policy meeting. Consequently, a hike itself from the ECB would likely have little effect on the European markets since most investors and traders are already positioned for such an outcome. However, the meeting will still have its impact on price action. Though a rate hike is all but priced in, the press conference that Trichet holds 45 minutes after the actual decision is still up in the air. It?s ironic that despite policy makers? efforts to be transparent, traders have just turned to another facet of the policy process to find their risk and therefore their short-term trades. Looking at the same rate futures that are pricing in a 25 basis point hike tomorrow, there is only a modest bias towards further rate hikes beyond June. This means that European policy makers? forecasts will take the reigns on price action. The lean towards further tightening is rooted in the persistence of the inflation and growth trends driving the Euro Zone and the large member economies. Since the May ECB meeting, the Euro Zone economic calendar has seen inflation hold its pressing 1.9 percent annual pace, the April jobless rate fall to its lowest level since records began in 1993 and consumer spending hold to positive territory. This could bring back vigilance? for a second round; but if the trend holds, the phrase should be absent for a month or two.
Bonds - 10-Year Euro Bund Futures
A rate hike from tomorrow?s ECB decision seems a formality at this point and price action in benchmark Euro-Bund futures reveal confirm that. Yields on the 10-year bund were falling steadily for nearly a month until the April meeting stalled futures at 113.35 support. The abrupt end to such a steady trend came when the ECB failed to revive the key vigilance? terminology after one meeting had already suffered from the loss. At the same time, when the central bank finally recalled the hawkish rhetoric last month, the bund quickly restored its downward bearing. Looking ahead to tomorrow, the rate hike is fully priced in and the absence of vigilance would not necessarily snuff out the advance in yields since the trend is: bring back vigilance? then let it lie for a month or two.
FX - EUR/USD
EUR/USD has barely managed to remain contained within a downtrending channel, as 240 minute charts show large wicks testing the upper trendline on the 12:00 EST and 16:00 EST candles. Will EUR/USD move higher and break out of the channel to test resistance at 1.3624 or will the pair plunge back towards support at 1.3400? Regardless of where EUR/USD goes next, the European Central Bank?s rate decision and ECB President Trichet?s subsequent press conference will be the fuel to get the price action going. There is no doubt that the central bank will hike rates to 4.00 percent, but the million dollar question is: what will they do in the second half of the year? This is particularly important in the EUR/USD pair, as markets are widely anticipating that the US Federal Reserve will leave their overnight rate on hold throughout the year. As a result, indications that the ECB will continue to tighten monetary policy at a faster pace than their US counterpart will only serve to benefit EUR/USD to keep the pair propped above 1.3500. However, if Trichet strikes a more neutral tone on Wednesday, traders will want to price in steady rates and EUR/USD may quickly sell-off towards 1.3400.
Equities - Xetra DAX 100 Index
German equity markets proved that they are just as vulnerable to central bank jawboning as FX markets as the Xetra DAX fell 0.7 percent to 7,919.83 after European Central Bank President Jean-Claude Trichet said: “The present state of global finance – where we are observing a level of risk pricing which is historically low – is not necessarily sustainable in the long run.” Furthermore, with the ECB anticipated to hike rates to 4.00 percent tomorrow, utilities, which are amongst the most sensitive to rising rates, led declines. E.ON, the world’s largest utility by sales, declined 1.3 percent to 120.17 euros while RWE, Germany’s second-biggest utility, slipped 1.3 percent to 83.14 euros. Airlines also suffered, as Ryanair Holdings Plc, the region’s biggest low-fare airline, forecasted slowing profit growth in fiscal 2008 as the company slashes ticket prices to attract passengers. Subsequently, Lufthansa, Europe’s second-largest airline, dropped 2.4 percent to 20.87 euros.
The Xetra DAX 100 Index could be in for trouble once again tomorrow, as a rate hike by the ECB would deter equity traders. However, it may be ECB President Trichet?s press conference at 12:30 GMT that will trigger the most substantial losses, as transparent policy by the central bank could yield more hawkish commentary. However, this will only be the case if the ECB sees the need for further policy tightening, as they recognize that their verbal cues are widely used amongst the markets and will not want to stir up the wrong expectations. As a result, even if the ECB raises rates as forecasted, any hints of a more neutral bias could actually lead Xetra DAX 100 up towards 8,000. On the other hand, an increase to 4.00 percent along with a consistently hawkish lean may drag the index down below 7,900.
