ECB Rate Decision (12:45 GMT; 07:45 EST)
Expected: 4.00%
Previous: 4.00%

How Will The Markets React?

There is little doubt that the European Central Bank will leave rates steady at 4.00 percent this week, but there is uncertainty surrounding what ECB President Jean-Claude Trichet will say during his monthly press conference following the rate announcement. During the October press conference, Trichet noted that “the outlook for price stability over the medium term is subject to upside risks” and that “the fundamentals of the euro area economy support a favorable medium-term outlook for economic activity.” However, Trichet also commented that caution must be “exercised when assessing any potential impact of the financial market developments on the real economy.” So has anything changed since October that will affect the ECB’s stance this time around? Trichet & Co. may have a hard time ignoring the surge in flash CPI estimates for October as the annualized rate rebounded to 2.6 percent from 2.1 percent in September. Trichet is known to be an ardent inflation hawk, but will it warrant “strong vigilance?” This phrase strikes a particularly strong note for central bank watchers as it has signaled an impending rate hike in the past. However, recent PMI figures for the manufacturing sector indicate that growth is slowing while both consumer and investor sentiment have turned more pessimistic, suggesting that the Euro-zone economy may be facing some road bumps. Furthermore, the financial markets have yet to fully recover, which may leave the ECB’s economic outlook uncertain. As a result, the ECB is likely to take a more firm stance on inflation risks but may not go as far as to cite the need for “strong vigilance,” which should leave the markets pricing in steady rates going into 2008.

Bonds – 10-Year Euro-Bund Futures

Euro-bund futures have reverted to a narrow range ahead of the ECB rate decision on Thursday bound by Fibonacci support at 113.66 and resistance at 114.15. However, the event risk lies not in the actual rate announcement but in ECB President Trichet’s subsequent commentary, as hawkish rhetoric will up the ante for rate increases in the future. Though we don’t not expect a return to the phrase “strong vigilance” which would suggest a rate increase on December 6, a sharpened focus in inflation risks could weigh Euro-bunds down though support to test the 113.18 level.

FX – EUR/USD

Broad-based weakness in the greenback has allowed EUR/USD to tear higher, with records being accomplished daily. Most recently, comments from a Chinese official suggesting that the government would diversify their $1.4 trillion in FX reserves away from US dollar sent EUR/USD spiking to 1.4704. There is little doubt that the climb of the EUR/USD is much more of a “US story”, but what about the Euro-zone. Economic conditions in the region remain relatively resilient, though the manufacturing sector has started to falter and sentiment amongst consumers and investors has soured. However, it is inflation that will get the European Central Bank’s attention on Thursday, when their next monetary policy decision is scheduled to be announced. The ECB is expected to leave rates steady at 4.00 percent, but markedly hawkish commentary by ECB President Trichet could spark even more gains for EUR/USD to target the 1.4750 level. On the other hand, if Trichet focuses more on the potential for an economic slowdown and the shaky financial markets, his comments could help EUR/USD ease back slightly.

Equities – Xetra DAX 100

The German Xetra DAX index has managed to hold to a range of approximately 7,786 – 8,041 over the past month or so, and though economic data doesn’t typically play much of a role in price action for the index, the ECB meeting could spark a bit of price action. The central bank is expected to keep rates steady, but a sharper tightening bias by ECB President Trichet may leave the markets expecting a hike in coming months which could weigh the DAX down. However, with the financial markets in Europe appearing to be relatively stable, the DAX will likely continue to work towards the 8,041 level once again.

Terri Belkas is a Currency Strategist at FXCM.