What Are The Markets Facing?

There is little doubt in the markets that the European Central Bank will raise rates on Thursday, as ECB President Jean-Claude Trichet remains the most hawkish central banker around. Mr. Trichet sparked expectations of a rate increase following the ECB’s June meeting, as he said during his monthly press conference that the ECB would “not exclude the possibility of increasing rates by a small amount.” Since the ECB’s primary mandate is to maintain price stability, Mr. Trichet has all the reason in the world to consider increasing interest rates as Euro-zone CPI estimates rocketed to a fresh 16-year high of 4.0 percent in June, up from a confirmed rate of 3.7 percent in May. This is substantially higher than the ECB’s 2.0 percent inflation target, and with CPI rising faster by the month, Mr. Trichet and other ECB Governing Council members are understandably concerned. However, traders will need to watch out for the other big show at 8:30 EDT, when Mr. Trichet will give his monthly press conference, as this tends to be the most market-moving part of the ECB’s rate decision. While maintaining price stability will remain high on Mr. Trichet’s list of priorities, his speech will likely signal that the rate hike was a one-and-done deal. Thus, traders should watch for comments that indicate that downside risks to growth may help to offset upside inflation risks, or notes that “the current monetary policy stance will contribute to achieving our objective” of price stability. However, there are other potential scenarios that could play out, which you can read about in our ECB Decision outlook.

Meanwhile, US non-farm payrolls and the unemployment rate will hit the wires at 8:30 EDT as well. NFPs are anticipated to reveal job losses in the US for the sixth consecutive month, while the unemployment rate is anticipated to ease back to 5.4 percent from 5.5 percent. However, US markets may only respond to the economic indicator that yields the greatest surprise factor. For more on the labor market data, check out Kathy Lien’s NFP outlook.

Bonds – 10-Year German Bund Futures

German Bunds continue to consolidate above the one-year lows at 109.66 ahead of Thursday’s ECB rate decision, when the bank is widely expected to hike by 25bps to 4.25 percent. The rate increase could send Bunds plummeting on Thursday, however, if Mr. Trichet suggests that there will be no additional rate hikes in the future, Bunds could subsequently recoup all of their losses and surge toward 111. On the other hand, a rate hike along with hawkish rhetoric by Mr. Trichet could push Bunds below 109.66.

FX – EUR/USD

A bullish run saw the EUR/USD break above resistance at 1.58, opening the door for the pair to target the record highs above 1.60. Looking ahead, EUR/USD faces two mammoth releases: the ECB Rate Decision and US Non-Farm Payrolls. Given current expectations, the news should allow the pair to further its rally. Nevertheless, there are a few factors to consider. While an ECB rate hike would be bullish for the pair, commentary by ECB President Trichet suggesting that tighter policy will not be necessary could actually lead EUR/USD to plunge as a 25bp increase is already priced in. Furthermore, if US NFPs are not quite as bad as expected or if the unemployment rate falls, the pair could fall back to trade near former resistance at 1.58, though sharper declines would take aim on 1.5725.

Equities – Dow Jones Industrial Average

Equities market shed early gains on Wednesday as the DJIA clearly broke below support at 11,300 amidst a surge in oil to $144/bbl and downgrades of GM shares from “Buy” to “Underperform” by Merrill Lynch. Given the steep declines in the index, the DJIA could simply consolidate near the recent lows at 11,183, especially since US markets will be closed on Friday for Independence Day. Nevertheless, the release of US labor market data could spark volatility early in the trading session. Market consensus indicates that employment situations are likely to worsen, and if figures fall in line with expectations, bearish sentiment could lead the DJIA to break below near-term support to target 11,042. If, however, the US unemployment rate decreases and payroll figures come in better than expected, the index could recover to rise toward 11,300 once again.

Terri Belkas is a Currency Strategist at FXCM.