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EUR/USD: Trading the European Central Bank Interest Rate Decision

Thu, Mar 5 2009, 06:04 GMT
by Daily FX Research Team

DailyFX

As market participants anticipate the Euro-Zone to face its worst economic downturn since World War II, the European Central Bank is widely expected to ease policy further this week, and the euro is likely to face increased selling pressures throughout the first-half of the year as the outlook for growth and inflation falter.

Trading the News: European Central Bank Rate Decision

What’s Expected

Time of release: 03/05/2009 12:45 GMT, 07:45 EST

Primary Pair Impact : EURUSD

Expected: 1.50%

Previous: 2.00%

Impact the European Central Bank Rate Decision has had on EURUSD over the last 2 months

February 2009 European Central Bank Rate Decision

ECB President Trichet and Co. held the key interest at the record-low of 2.00% in February, which was in-line with expectations, but is likely to cut borrowing costs further in March as economists forecast the euro-region to face its worst economic downturn since World War II. The lack of urgency in President Trichet’s policy to restore confidence in the economy has spurred criticism that the central bank is doing too little too late, and that they are failing to realize the severity of the recession. Nevertheless, the central bank head signaled that the board may lower rates by 50bp in March to 1.50%, which would be the lowest level since the euro was introduce in 1999. Meanwhile, the ECB remained reluctant to adopt a zero interest rate policy over the near-term even as the IMF expects the annual rate of growth to contract 2.0% this year, stating that zero rates are not ‘appropriate at this stage.’

January 2009 European Central Bank Rate Decision

The European Central Bank lowered borrowing costs by another 50bp to 2.00% in order to stimulate the ailing economy, but may keep rates on hold at their next policy meeting in February as President Trichet remains reluctant to overshoot the interest rate. Mr. Trichet went onto say that the outlook for medium-term inflation remains ‘broadly balanced and in line’ with their one and only mandate to ensure price stability, but as price pressures alleviate at a rapid pace, the ECB could be forced to lower rates further in order to maintain their 2% target for price growth. As the central bank is expected to revise their forecast for growth and inflation in March and expect a ‘significant’ downturn in the economy, policy makers are likely to lower the benchmark interest rate further during the first half of the year as the economy heads into a deepening recession.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario:

If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the Euro against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on EURUSD ahead of the data release.

Bearish Scenario:

If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the Euro against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on EURUSD ahead of the data release.

How To Trade This Event Risk

As market participants anticipate the Euro-Zone to face its worst economic downturn since World War II, the European Central Bank is widely expected to ease policy further this week, and the euro is likely to face increased selling pressures throughout the first-half of the year as the outlook for growth and inflation falter. A Bloomberg News survey shows that all of the 55 economists polled forecast the ECB to cut the benchmark interest rate by 50bp to 1.50%, which would be the lowest level since the single-currency was introduce in 1999, and may have room to lower borrowing costs further in the months ahead as price pressures alleviate. The CPI report for January showed that the annual rate of inflation grew at 1.1% during the month, which is the lowest level of growth in over a decade, and as the risks for deflation intensify, policy makers are likely to step up their efforts in order to maintain the 2% target for inflation. Meanwhile, the advanced GDP reading for the euro-region showed that the economy contracted 1.5% in the fourth quarter, which was the biggest drop since recordkeeping began in 1995, and lowered the annual rate of growth to -1.2% to mark its first full-year contraction. In addition, economic confidence throughout the region fell to a record low in February while the unemployment rate rose to a two-year high in January, and conditions are likely to get worse as the region faces a deepening recession. Despite the dire state of the economy, ECB President Trichet remains reluctant to overshoot the interest rate and continues to undermine the effectiveness of adopting a zero interest rate however, voting member Athanasios Orphanides rebutted the unconstructive attitude held by central bank head, stating that the implications for monetary policy to become ineffective as rates near is a ‘dangerous fallacy,’ which could force policy makers to lower rates further and adopt unconventional measures to stimulate the ailing economy. As a result, deteriorating fundamentals paired with increased turmoil in the banking sector will stoke increased pressures for the ECB to ease policy further as the outlook for future growth remains bleak, which is likely to weigh on the exchange rate going forward. At the same time, as investors continue to curb their appetite for risky assets, the euro should continue to hold its bearish trend against the U.S. dollar over the near-term as the reserve currency continues to benefit from safe-haven flows.

Trading the given event risk clearly favors a bearish forecast for the euro as the ECB is expected to lower the benchmark interest rate to a fresh record low however, as President Trichet remains reluctant to push they key rate ‘too low,’ if the central bank head reinforces his unwillingness to lower rates close to zero and signals that the board will hold a neutral policy stance going forward, we will look for a green, five-minute candle following the decision to confirm a buy entry on two lots of EURUSD. Once these conditions are met, we will place our initial stop at the nearby swing low (or reasonable distance taking volatility into account), and this risk will establish our first target. Our second target will be based purely on discretion, and in an effort to preserve our profits, we will move the second lot to breakeven once the first trade reaches its target.

Conversely, mounting turmoil in the banking sector paired with fears of a deepening recession may lead the ECB to take an aggressive step to shore up the economy, and may consider cutting the interest rate further as the outlook for growth and inflation deteriorate at a record pace. As a result, if the ECB lowered the key rate by 50bp or more, and raises the possibility of adopting a zero interest rate policy over the near-term, we will look to sell the single-currency, and will follow the same setup for a short euro-dollar trade as the long position mentioned above, just in reverse.

Published on  Thu, Mar 5 2009, 06:12 GMT