On Thursday, May 8, the Bank of England and the European Central Bank will each announce their monetary policy decisions. Expectations are for both banks to leave rates steady, but there is some speculation that one may actually enact a rate cut, which may create interesting opportunities when trading the Euro and British Pound this week.

Bank of England – Risks Tilted Toward Additional Rate Cuts This Year
Rate Announcement: May 8, 2008 at 11:00 GMT
Bias: No Change

The Bank of England is expected to leave rates steady on Thursday at 5.00 percent – the lowest since December 2006 – after cutting by 25bps during their last meeting. The rate decision will come at 7:00 EDT but since the Monetary Policy Committee is anticipated to leave rates unchanged, they are unlikely to issue a monetary policy statement which should leave the market’s reaction to the news somewhat muted. Nevertheless, given the fact that the vote for the April rate cut included six in favor of the 25bp reduction, two votes for no change, and one vote for a 50bp cut, it’s clear that there is major disagreement amongst the Committee on what their next move should be.

What are the fundamental factors that the MPC will be taking into account? Inflation pressures in the UK have not been quite as strong as in the Euro-zone, as CPI surprisingly held steady at an annualized pace of 2.5 percent in March. However, this is still well above the BOE’s 2 percent target as robust energy and food prices prop the index higher. Furthermore, BOE Governor Mervyn King said last week, “It is likely that inflation in the next 12 months will hit 3 percent and possibly higher.” However, King also said that “the Committee have judged that it would not be sensible to raise interest rates significantly at this stage in order to induce a recession to try and keep inflation below 3 percent. As long as food and energy prices don't continue to rise at the same rate, they can stay at these high levels, inflation would fall back.”

These expectations that inflation pressures will ease in coming months is only part of the reason why dovish MPC members like David Blanchflower continue to vote for aggressive rate cuts. Furthermore, the economy is gradually deteriorating, and conditions are likely to get worse. According to data released over the past week, the services sector is slowing rapidly as PMI fell to a multi-year low of 50.4; just barely managing to hold above the 50 level to signal expansion, whereas a drop below 50 would indicate contraction in the sector. Meanwhile, PMI manufacturing dipped down to a reading of 51.0 from 51.3, but given the unexpected 0.5 percent drop in industrial production, it is clear that both demand for and output of UK-made goods are waning. However, the most vulnerable point of the UK economy is eerily similar to that of the US – the housing sector. Both the HBOS and Nationwide house price reports showed declines of over 1 percent during the month of April alone, while mortgage approvals plummeted to an ultra-weak 64k from 72k, which marks the lowest reading since record keeping began in 1993. Additionally, PMI Construction fell to 46.1 in April, which not only signals contraction but is also the softest reading in nearly ten years. It is not just the residential property market that is in distress according to the MPC’s most recent Financial Stability Report, as the Bank noted major risks from a plunge in commercial property values, which could lead to significant losses for UK banks on losses related to commercial mortgage-backed securities (CMBS). This has stoked concerns that the UK is in for a US-style property market collapse that could trigger the next big credit crunch and all-out UK recession.

Given these significant downside risks for the UK economy as a whole, there will likely be at least one or two votes in the MPC for a 25bp cut this week. However, the majority of the Committee will probably be more concerned about upside inflation risks given the ascent of crude oil futures to record highs above $123/bbl. We will not know the exact vote count for sure until the release of the minutes from this MPC meeting later in the month. As a result, the British pound could actually rally if the BOE leaves rates unchanged in line with expectations, especially as the currency has tumbled ahead of the meeting as traders price in the potential for a small rate cut.

European Central Bank – Still Hawkish, But No Hike.
Rate Announcement: May 8, 2008 at 11:45 GMT
Bias: No Change

The European Central Bank is expected to leave rates unchanged at 4.00 percent, but traders will be far more interested in the tone of ECB President Jean-Claude Trichet’s remarks, rather than the highly anticipated policy statement. Throughout the first quarter of 2008, Mr. Trichet has been unrepentantly hawkish, stressing the need to control prices first and foremost. Upside prices pressures persists to be the main area of concern for the ECB President Trichet, and while we saw estimates for Euro-zone CPI in April plunge to 3.3 percent from 3.6 percent, this is still well above the ECB’s 2 percent target as energy and food costs remain high. Indeed, Trichet’s emphasis on inflation rather than growth stems from the ECB’s mandate, which in contrast to the Federal Reserve, commands the Bank to maintain price stability rather than stimulate growth. However, the other reason for Mr. Trichet’s steadfast commitment to a restrictive monetary policy is due to the fact that for most of the first quarter, the Euro-zone has been largely insulated from the negative impact of the credit crunch that afflicted the US economy, sparking speculation that the region could decouple from the economic slowdown in the US.

Indeed, while the US economy has experienced job losses for the past three months in a row, Euro-zone labor markets continued to expand as the unemployment rate holds at 7.1 percent - the lowest reading in this decade. The buoyant employment picture has allowed ECB officials to maintain its tight monetary policy without inflicting too much pain on domestic demand. However, there are signs that economic activity in the Euro-Zone is beginning to come under pressure, most notably in the consumer sector. The latest retail sales report for the Euro-Zone reflected a sharp 1.6 percent drop on an annual basis from a previous reading of 1.0 percent. Meanwhile, consumer confidence remains pessimistic as the European Commission’s index has held at a dismal -12 for the past four months, while business sentiment has slowly deteriorated for the past five months. Furthermore, lackluster demand in Europe and abroad has led manufacturing activity to steadily declined, as PMI hit a record low of 50.7, barely signaling expansion.

In short, the global slowdown in growth is beginning to spillover into Euro-zone economy and the currency market will be watching carefully to see if Mr. Trichet acknowledges that fact. The ECB does not like to surprise the markets, preferring instead to improve its transparency by preparing investors for any policy changes well in advance. Therefore, if Mr. Trichet chooses to de-emphasize price pressures and instead focuses on the possible downside growth risks to the Euro-zone economy, traders will interpret his words as a sign that the ECB’s monetary policy bias has turned from restrictive to neutral. In that case, with no future prospect of any additional rate hikes in the Euro-zone, traders are likely to sell the euro across the majors on a wave of profit taking. On the other hand, if the ECB remains stalwart in their focus on inflation, the currency could continue to be bid on the same de-coupling theme that initially pushed the unit to record highs against the dollar.

Will The Rate Decisions Help Derail The EURGBP Rally?

Technically, the massive rally we’ve seen in EURGBP may have hit an intermediate top. According to Technical Strategist Jamie Saettele, the drop from .8097 is probably a larger 4th wave. 4th waves tend to be complex in their structure, which makes trading them difficult. However, as long as the series of lower highs is intact since .8097, a bearish bias is warranted against .7947 (most recent ‘swing high’). The initial bearish objective is not until former resistance (which will probably act as support going forward) at .7612). Adding the fundamental environment to the mix, the simple combination of no change in rates by the Bank of England at 7:00 EDT followed by noticeably less-hawkish commentary by European Central Bank President Trichet at 8:30 EDT could be enough to weigh EUR/GBP down toward noted support at 0.7612.

David Rodriguez is a Currency Analyst at FXCM.