Preview of Thursday's ECB Meeting

In April, the ECB elected to lower the refinance rate by 25 basis points to 1.25%, refrained from adopting quantitative ease and indicated that they would make a decision on nonstandard policy measures at the May policy meeting. The ECB meets Thursday, May 7th with policy members divided over how much lower interest rates should go and whether the ECB should adopt nonstandard policy measures. The ECB lowered interest rates 300 bps since last October and has been reluctant to adopt quantitative ease.

Thursday's ECB policy meeting has the potential for significant impact on the EUR. The ECB is expected to lower interest rates 25 bps to 1%. It's unclear if ECB will signal a floor for the refi rate or adopt nonconventional measures. A 25 bps rate cut is already discounted. A steady policy decision would be a mild positive for the EUR. The announcement of the implementation of nonstandard policy measures could spark selling of the EUR. The ECB meeting is a significant event risk for the EUR because it will bring the ECB closer to adopting nonstandard monetary measures. There are three key questions to look for at the May ECB policy meeting: 1) what is the lower limit for ECB interest rates, 2) what nonstandard policy measures are the ECB considering and 3) when might the ECB elect to implement nonstandard policy measures.

Recent comments from ECB officials suggest that some of the policy board members prefer not to cut interest rates below 1% (Weber), other members including Wellink said they may support an ECB rate cut below 1%. The main reason for divisions about lowering interest rates among the ECB members include concern that if interest rates fall too much it will hurt the functioning of money markets. ECB members are also generally optimistic that the EU economy will recover later in 2009 and see limited risk of deflation. The ECB does not have the same sense of urgency that prompted the Fed and Bank of England to lower interest rates towards zero and adopt quantitative ease.

Low limit for ECB refinance rate:

The low limit for the ECB's refi rate may be 1% or perhaps 0.75% but it's clear that ECB does not want to move to zero rate policy. ECB President Trichet says if rates fall too low it could hurt the functioning of the money markets. The ECB may signal that policy is nearing the low limit for refi rate at 1% floor. According to ECB's Stark, the ECB will decide about the “moderate” room to maneuver on interest rates and make a decision on non-standard measures at the May meeting. Stark said that the nonstandard measures will be implemented when the lower interest rate limit is reached.

The lower limit for the ECB interest rates and adoption of nonstandard measures has been openly debated by ECB board members. ECB's Weber says he would prefer not to cut interest rates below 1% or buy corporate assets. ECB's Wellink says that he may support an ECB rate drop below 1%. ECB Pampademos and Nowonty have also said they favor asset purchases. ECB president Trichet said the ECB will do everything possible to restore prosperity. The floor for ECB interest rates and the timing of the adoption of nonstandard policy measures will largely hinge on ECB board members outlook for the EU economy and inflation.

The EU Economy is in recession but there are signs of stabilization. EU inflation is declining. Recent EU economic data including improvement in manufacturing and services PMI, consumer confidence and retail sales, suggest that the EU economy is stabilizing. Unemployment, however, continues to rise and has hit a three-year high of 8.9% in April. Bank lending remains slow. EU April inflation rate declined to 0.6%, well below the ECB's 2% target. April PPI declined at its fastest pace in 22 years. Because the economy remains weak and inflation low, the ECB may take action to try and encourage lending in the EU. As interest rates approach zero, the ECB will no longer be able to rely on interest rate cuts alone.

Non nonstandard policy measures:

The ECB is expected to adopt the agenda for quantitative ease but may stop short of authorizing the implementation of nonstandard measures at the May meeting. The ECB is reluctant to adopt quantitative ease because ECB officials do not see the same risk of deflation or economic deterioration as in the US and UK. Lending in EU is primarily done through the banking system rather than securities markets. Bank lending in the US accounts for just 30% of credit creation compared to 70% in the EU. Because lending in the EU is primarily done through the banking system rather than security markets, the ECB will likely consider measures to ease credit conditions for banks. The ECB most likely will consider a plan to extend lending to banks from the current six month period to the twelve months. The goal is to increase liquidity. Other nonstandard measures that the ECB may consider are the purchase of private-sector bonds and government bonds. The EU corporate bond market is relatively small and the EU does not have a unified government bond market. This could make it difficult for the ECB to determine which corporate or government bonds to buy to try to increase liquidity and improve credit conditions. Because lending in the EU is primarily done through the banking system rather than security markets the ECB will likely consider measures to ease credit conditions for banks and adopt measures to buy bonds as a last resort.

What impact will be ECB policy decision have on the EUR?

The ECB most likely will cut rates to 1.00%, announce details of nonstandard policy measures and take a wait and see approach as to when to implement these measures. A 25 bps ECB rate cut is discounted by the market and would have limited impact on EUR trade. If the ECB elects to adopt nonstandard financial measures the EUR may experience short-term selling pressure similar to the reaction to the Fed and BOE's implementation of adoption of quantitative ease which sparked a short term decline in the USD and GBP. A decision to implement nonstandard measures at this time is unlikely with global equity markets at a four-month high and LIBOR rates falling below 1%.The rally in equity markets and decline in LIBOR rates suggest the global economy is stabilizing and credit markets tensions have eased.

If the ECB presents its quantitative easing agenda but stops short of implementation, the EUR may see a rally similar to the reaction in the CAD, after the BOC outlined its quantitative ease strategy and decided to hold off implementation of quantitative ease. The ECB will likely set the agenda for nonstandard measures. The ECB does not see a strong risk of deflation or have the same sense of urgency as the FED and the BOE to adopt quantitative ease. This means that the nonstandard policy measures that the ECB may rely on will be different than the quantitative ease in the UK and US with the ECB relying on banking channels and providing bank related credit financing. ECB policy will remain less aggressive than the Fed and Bank of England. Less aggressive ECB monetary ease would be a positive for the EUR.

The main risk to the EUR is a possible shift in market focus to growth differential and speculation that the US and UK economy will recover before the EU as the ECB stops short of implementing quantitative ease. Trichet's press conference following the rate decision will be key to future ECB policy outlook and to answering questions on how low interest rates may go and the type of nonconventional policy measures are being considered by the ECB. Note in the graph below that the EUR remains range bound but is approaching trendline resistance near 1.3500.A break of this level could spark a rally towards 1.4000. Expect key EUR/USD support at 1.3130 the April 29th low. The preferred strategy is to buy breaks in the EUR into support above 1.3130.

By Michael J. Malpede

Easy Forex
http://www.easy-forex.com

Michael J. Malpede is Chief Market Analyst with Easy-Forex® and has previously been featured on Bloomberg TV, Bloomberg radio, Reuters, MarketWatch, Wall Street Journal, Chicago Tribune, Chicago Sun Times, Toronto Star and Nikkei press. In analyzing the markets, he draws from 29 years of Foreign Exchange Research as a Foreign Exchange Analyst.

Please note that Forex trading (OTC Trading) involves substantial risk of loss, and may not be suitable for everyone. This report is provided by Easy- Forex® for informative purposes only. In no way it is a recommendation by Easy-Forex® for you to engage in any trade. It is your sole responsibility and you will have no claims with regards to this report against Easy-Forex®. If you do not agree to this, you are strongly advised not to use this report. Hence, Easy-Forex® shall not be held responsible for any outcome of trading decisions, in regards with this report or similar reports.