ECB Rate Decision (12:45 GMT; 07:45 EST)
Expected: No Change, 4.00%
Previous: 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. Since we expect the Bank of England to leave rates unchanged at 5.25 percent, we’ll focus on the European Central Bank’s rate decision since the news may be a bit more market-moving. The ECB is 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 beyond the bank’s 2.0 percent ceiling to 3.2 percent in February. Indeed, there is little doubt ECB is dealing with rampant consumer price growth, but economic conditions have started to deteriorate in recent months as fourth quarter GDP for the region slowed a bit more than expected to an annual rate of 2.2 percent form 2.6 percent. On the other hand, investor and consumer confidence surveys from ZEW, IFO, and the European Commission have stabilized, despite the dim growth prospects for 2008 and the negative impact of higher energy and food costs on disposable income. Furthermore, concerns of a spill-over effect from weak US demand in Europe has been allayed as demand from Eastern Europe and other emerging economies has helped buoy exports. Nevertheless, the deal-breaker for rate expectations after this meeting depends on whether or not Trichet will remain hawkish in his subsequent policy statement: If the ECB President keeps his focus on maintaining “price stability”, the markets will judge that the bank will stay neutral through the first half of 2008. However, if the policy statement focuses more on the downside risks to growth or issues some verbal intervention by mentioning that the Euro is uncomfortably strong and could impair growth, the markets may consider the possibility that rate cuts loom on the horizon.

Bonds – 10-Year German Bund Futures

Bunds have managed to hold above support at the 117.16 level, and with risk aversion propping fixed income markets globally, the daily charts still look bullish. However, heavy resistance loom near 118 and event risk from the ECB’s meeting could trigger a correction lower, as Trichet may continue to issue hawkish rhetoric. On the other hand, a shift to a focus on the downside risks to growth and indications that a rate cut looms on the horizon could push Bunds to test resistance at the January 22 high of 118.08.

FX – EUR/USD

Although the ECB is expected to announce that they will maintain interest rates at 4.00 percent on Thursday, the decision still carries significant event risk for the EUR/USD pair. It is widely known that ECB President Jean-Claude Trichet is a staunch inflation hawk who continually reminds the markets that “price stability” is the central bank’s primary concern. With flash estimates for February CPI holding at a whopping 3.2 percent, Trichet’s bias has assured many that the central bank isn’t even considering reducing rates in the near-term. If the ECB maintains this stance this week, EUR/USD could surge above the record high of 1.53 to target 1.5391. However, any hint by the transparent Trichet that his bias is becoming more dovish, or commentary noting that the value of the euro is uncomfortably high could send the pair tumbling towards 1.5140.

Equities – Xetra DAX Index

The German Xetra DAX Index has managed to recover somewhat after testing the 6,500 level on Tuesday, as traders become a bit more risk seeking to the benefit of carry trades. However, commentary by ECB President Trichet could shake the index up on Thursday, as a pronounced focus on downside risks to growth could lead the DAX to fall towards 6,500 once again, with sharp drops targeting the January 22 low of 6,384. On the other hand, if the central bank remains confident that a slowdown in global growth will not impair the Euro-zone economy significantly and that a rate cut will not be needed in the near term, the index could bounce towards 6,750. Nevertheless, broad risk aversion trends remain the primary driver of many stock markets – including the Xetra DAX Index – so traders should beware of volatile price action in Asian markets the evening before.

Terri Belkas is a Currency Strategist at FXCM.