BOE Rate Decision (12:00 GMT; 07:00 EST)
Expected: No Change, 5.50%

ECB Rate Decision (12:00 GMT; 07:00 EST)
Expected: No Change, 4.00%

What Are The Markets Facing?
On Thursday, two major central bank decisions are scheduled to be released, and the results could have a large impact on the markets, particularly in FX. The Bank of England is forecasted to leave rates steady at 5.50 percent, though they are considered to have a dovish bias after it was revealed that the December 25bp cut was a unanimous decision. Meanwhile, the European Central Bank is also forecasted to leave rates steady at 4.00 percent, but they are perceived as holding a hawkish bias, as recent inflation estimates show CPI rocketing above the bank’s 2.0 percent ceiling to 3.1 percent in December. First, let’s take a look at what these two banks have in common: the global credit crunch that has rocked the markets since August previously led European and UK interbank lending rates (Libor) to jump to multi-year highs while equity markets remain especially jittery and prone to declines. However, credit market conditions have improved since then, though equity markets have dropped rapidly, and both the BOE and ECB remain uneasy amidst expectations for a global growth slowdown in 2008.

Now let’s differentiate. The BOE took quite a bit of flak for the bank run on Northern Rock in September, and the financial sector continues to get battered in the equity markets. Meanwhile, housing data has steadily deteriorated with the most recent reading from Nationwide Building Society showing prices falling for a second consecutive month in December, while consumer confidence and spending have waned. Meanwhile, both headline and core CPI were softer than expected in November at 2.1 percent and 1.4 percent, respectively, which leaves the BOE far more leeway to make monetary policy more accommodative, especially as inflation outlooks project easing price pressures. In fact, BOE MPC member Timothy Besley issued a research paper in December that found that interest-rate decisions tend to reflect inflation forecasts, which helps to explain why 9 out of 50 economists polled by Bloomberg News currently believe the central bank will cut rates by 25bp on Thursday. However, the majority believe that they will leave rates on hold, as do we. Indeed, the BOE will likely prefer to take a gradual approach to rate cuts, so as to not fan any existing price pressures.

Meanwhile, the ECB is dealing with rampant consumer price growth, but economic conditions have started to deteriorate according to Q4 reports. Euro-zone PMI for the manufacturing sector dropped as exports suffer while retail sales and services PMI were softer than expected on lackluster domestic demand, and with consumer confidence falling to the weakest reading in nearly two years in December, household spending is unlikely to rebound significantly anytime soon. However, the deal-breaker for rate expectations is whether or not Trichet will remain hawkish in his subsequent policy statement: If the ECB President notes the phrase “strong vigilance,” traders may immediately start betting on a hike in January, as this has previously served as an excellent signal of impending policy action. Conversely, if the policy statement focuses more on the downside risks to growth, the markets judge that Trichet’s monetary policy tightening cycle is done for good.

FX – EUR/GBP

The EUR/GBP pair has climbed steadily over the past few months, as the European Central Bank has remained unabashedly hawkish with CPI remaining hot, while the Bank of England has actually started to cut rates and the housing sector looks prone to slowing dramatically. On Thursday, this pair may be the best option for FX traders looking to play the event risk from the ECB and BOE rate decisions. The pair could falter if the BOE does not cut rates and does not issue a policy statement, as dismal UK data has led speculation of more accommodative monetary policy to mount. Furthermore, if the ECB’s Trichet focuses more on financial market instability and downside risks to growth rather than inflation, weakness in the Euro against many of the majors – including the British Pound – may ensue. Technically, the massive rally we’ve seen in EUR/GBP may be nearing an end as the pair closes in on the 0.7550 level. According to Technical Strategist Jamie Saettele, the rally has extended in a larger wave 3 (within the 5 wave rally from .6535), and since the pair trades at an all-time high there is nothing to go on as far as chart resistance is concerned. The form of the advance indicates that the EURGBP is likely to consolidate before making a new high. A corrective 4th wave would follow and likely last a few months, taking the pair back towards .7100-.7200 before a rally to complete the entire rally from .6535 in wave 5.

Terri Belkas is a Currency Strategist at FXCM.