European Central Bank Interest Rate Decision
Expected: 4.00%
Previous: 4.00%

How Will The Markets React?

Forex traders will pay very close attention to the upcoming European Central Bank interest rate decision, with the Euro/US Dollar exchange rate hinging on outlook for yield differentials. Analysts clearly expect that the central bank will leave rates unchanged at 4.00 percent through the meeting, but subsequent commentary will definitely guide forecasts for the ECB’s next rate move. The euro has gained significantly against its US counterpart on a fast-shrinking yield disadvantage through recent trade. Given the US Federal Reserve’s decision to cut interest rates by an unexpected 0.50 percent, the greenback’s rate spread against the euro shrunk to a paltry 0.75 percent. Forecasts for further Fed rate cuts and potential ECB rate hikes have fueled the EURUSD rally, but a shift in sentiment could easily undermine EURUSD. An examination of European asset prices suggests that euro bulls may have an uphill battle on their hands, as we see little expectations of ECB rate hikes through year-end.

Bonds – 2-Year German Bund

German bond yields have sharply declined from previous heights, as speculators scale back expectations of rising European interest rates. Given a backdrop of fast-falling US Treasury Yields, this has had little negative impact on the EUR/USD. Yet a recent moderation in rate cut expectations for the US and speculation over potential ECB rate cuts has served to force a euro correction for the third consecutive trading day. Looking at German government bonds, this has coincided with a drop in 2-year yields. Fixed income traders likely fear that central bankers will take a more dovish tone in tomorrow’s key post-announcement statement, leaving bearish implications for the euro ahead of the release.

FX – EUR/USD

The EUR/USD has shown a noteworthy correction from recent record heights, as traders begin to scale back extended positioning ahead of critical European and US event risk. Tomorrow’s European Central Bank interest rate decision and statement will undoubtedly have its effects on the currency pair, and the euro’s recent drop suggests that forex speculators fear the worst. According to some analysts, there are rumors that the ECB will cut rates to halt the euro’s advance. Though highly unlikely, we cannot completely ignore the possibility of such measures, and we believe risks are weighed to the downside for the euro ahead of the release. If the central bank takes a more aggressive stance on monetary policy and remains hawkish, however, the EURUSD could easily see strong bids on forecasts for stable or rising European interest rates.

Equities – German DAX Index

European stock markets have rebounded sharply from recent depths, with the German DAX now 7.3 percent higher on the year. Improved risk appetite has clearly been the main driver behind a retracement of losses, but the extent to which markets have rallied suggests that traders no longer fear that the European Central Bank will raise interest rates. This is consistent with price action in other asset classes, and recent speculation that the ECB may actually cut rates may drive further rallies. Such an outlook clearly depends on tomorrow’s rate decision and subsequent commentary; strong reactions are guaranteed on any significant shift in rhetoric.

Terri Belkas is a Currency Strategist at FXCM.