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Trading News Report

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

Thu, Apr 2 2009, 06:17 GMT
by Daily FX Research Team

DailyFX

The European Central Bank is widely expected to lower the benchmark interest rate by 50bp to a record-low of 1.00% as the outlook for growth and inflation falter. A Bloomberg News survey shows that 49 of the 55 economists polled forecast the central bank to lower borrowing costs further as the region faces its worst economic downturn in over half a century however, as ECB President Trichet remains reluctant to over shoot the interest rate, the board may implement new tools to stimulate the ailing economy rather than cutting the rate further as the central bank avoids being stuck in a ‘liquidity trap.’

Trading the News: European Central Bank Rate Decision

What’s Expected

Time of release: 04/02/2009 11:45 GMT, 07:45 EST

Primary Pair Impact : EURUSD

Expected: 1.00%

Previous: 1.50%

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

March 2009 European Central Bank Rate Decision

The European Central Bank lowered the benchmark interest rate by 50bp in March to a record low of 1.50% in an effort to mitigate the downside risks for growth and inflation. As the euro-region faces its worst recession in over half a century, economic activity across the 16-nations operating under the single-currency has weakened considerable, and as ECB President Trichet continues to reinforce his reluctance to over shoot the interest rate, the policy stance help by the central bank could prolong the downturn in Europe as the board underestimate the depth of the financial crisis. Moreover, market participants have argued that the central bank needs to adopt additional tools to soften the landing of the economy, and that the ECB’s sit-and-wait approach could pose a threat to long-term stability as the central bank fails to realize the severity of the recession.

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 has done 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, Mr. Trichet remained reluctant to over shoot the interest rate 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.’

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

The European Central Bank is widely expected to lower the benchmark interest rate by 50bp to a record-low of 1.00% as the outlook for growth and inflation falter. A Bloomberg News survey shows that 49 of the 55 economists polled forecast the central bank to lower borrowing costs further as the region faces its worst economic downturn in over half a century however, as ECB President Trichet remains reluctant to over shoot the interest rate, the board may implement new tools to stimulate the ailing economy rather than cutting the rate further as the central bank avoids being stuck in a ‘liquidity trap.’ As the board contemplates the adverse effects of a zero interest rate policy and struggle to meet on common ground, market participants speculate that policymakers could opt to extend the maturity of its refinancing programs for banks in an effort to restore confidence in the financial markets, while ECB Vice-President Lucas Papademos said that the central bank could purchase ‘private debt securities in the secondary market in order to improve its liquidity.’ On the other hand, some have argued that the ECB will ultimately adopt policies in-line with the Fed and the Bank of England as the downturn in the global economy intensifies, while others see the possibility for the central bank to purchase Eastern European currencies in an attempt to stem the systematic risks for the Euro-Zone economy. Meanwhile, as the Organization for Economic Cooperation and Development expects economic activity in the region to contract 4.1% this year and forecasts inflation to grow at an annualized pace of 0.6%, the group has called for the ECB to lower rates quickly and to purchase securities through open market operations in order to drive up the money supply, and went onto say that the governments in the region should expand their fiscal stimulus objectives to jump-start the economy. As a result, comments from President Trichet following the rate decision are likely to move the markets, and may help to shed some light for future policy however, if the central bank head fails to provide a concrete plan to counter the downturn in the economy and focuses on implementing the extraordinary measures already taken by the board, fears of a deepening recession paired with the weakening outlook for price growth is likely to weigh on the exchange going forward. At the same time, if the ECB concludes its easing cycle, and provides a sturdy outlook for future policy, a rise in market sentiment could boost demands for the single-currency.

Trading the given event risk may not be as clear cut as some of our other trade but nevertheless, as market participants expect the ECB to conclude its easing cycle and anticipate the central bank to hold the benchmark interest at the record-low of 1.00% over the medium-term, long-term expectations for higher interest rates could spark a rally in the euro. Therefore, we will look for a green, five-minute candle following the release to consider a buy entry on two lots of EUR/USD however, we would recommend wait for further confirmation before entering the position as President Trichet holds the Q&A session at 12:30 GMT. If market conditions pave the way for a long euro trade, we will place our initial stop at the nearby swing low (or reasonable distance taking volatility into account), and this risk will determine our first target. Our second target will be based purely on discretion, and in an effort to preserve our profits, we will move the stop on the second lot once the first trade reaches its target.

On the other hand, as the outlook for growth and inflation remains bleak, increased risks for deflation could warrant another rate cut by the ECB, and if President Trichet drops his reluctance to lower the benchmark interest rate further, we would certainly favor a bearish forecast for the euro. As a result, if the central bank head reinforces expectations for lower borrowing costs, we will look to sell the single-currency, and will follow the same strategy for a short euro-dollar trade as the long position mentioned above, just in reverse.

Published on  Thu, Apr 2 2009, 06:23 GMT