Euro, British Pound to Dominate Headlines Thursday Amidst ECB, BOE Rate Cuts

The euro and British pound both edged lower on Wednesday, and while all the European economic data in the world argues in favor of weakness for the two currencies, the price action we’ve been seeing lately has had more to do with the very broad trend of flight-to-quality into “safe-havens” like the US dollar. However, on Thursday, the monetary policy decisions scheduled to be announced by the European Central Bank and the Bank of England have the power to shake these currencies up. What should you expect?

European Central Bank - A Bloomberg News poll of 55 economists shows that the European Central Bank is very likely to cut interest rates by 50bps to a nearly 2-year low of 3.25 percent at 7:45 ET. Indeed, economic conditions have deteriorated rapidly throughout the region, with the October PMI readings showing that business activity in the Euro-zone’s manufacturing and services sectors has been contracting for five consecutive months. Meanwhile, Eurostat’s estimate of Euro-zone CPI shows that price growth eased to a 3.2 percent pace in October from 3.6 percent. Given European Central Bank President Jean-Claude Trichet’s more bearish stance on the economy and the bank’s participation in the October 8 coordinated rate cuts, the indications of cooler inflation pressures gives the ECB even more room to cut rates on Thursday. The reaction of the euro, however, may depend more on Mr. Trichet’s post-meeting press conference at 8:30 ET as his speeches tend to be very straightforward and biased. If Mr. Trichet suggests that the ECB will cut rates further, the euro is likely to take a sharp hit but if he signals a more neutral stance going forward, the currency could actually rebound.

Bank of England - The Bank of England is widely anticipated to follow up their October 8 rate cut with yet another 50bp cut to 4.00 percent at 7:00 ET, as the UK economy tips into recession and the financial markets remain unstable. While UK CPI remains well above the BOE’s 2 percent target and 3 percent ceiling at 5.2 percent, weaker commodity prices have led inflation outlooks around the world to drop rapidly. Furthermore, BOE Monetary Policy Committee member David Blanchflower, who has long been the most dovish of all the members since joining the Committee in mid-2006, was as staunch in his bias as ever when he noted that he thought deflation was a bigger concern than inflation, and that CPI may fall from the September reading of 5.2 percent down to 1 percent, or could even go negative. Mr. Blanchflower also said that UK interest rates must be lowered significantly and quickly. While a Bloomberg News poll of economists shows that the odds are in favor of a 50bp reduction, Credit Suisse overnight index swaps are actually fully pricing in a 75bp cut. If the BOE does indeed slash rates more than expected, the British pound could fall quite a bit.

US Dollar Modestly Higher on 5% Drop in Stock Markets, 7% Plunge in Crude Oil

No surprises here: US economic data was all around disappointing, and yet, the US dollar ended the day modestly higher versus its counterparts. In fact, the only major currency that was stronger than the greenback was the Japanese yen, and given the more than 5 percent decline seen in the US stock markets and 7 percent plunge in oil on Wednesday, it’s clear that risk trends continue to dominate the financial markets (see our latest forex correlations report for more). Looking at the data on hand today, ISM non-manufacturing fell more than expected to a record low of 44.4 in October from 50.2, with the drop below 50 signaling a sharp contraction in business activity. Business activity, new orders and backlogs all plunged while new export orders stagnated and employment tumbled to its own recent record low of 41.5. Meanwhile, the prices paid component tumbled to 53.4 from 70, suggesting that lower costs may allow businesses to pass the savings on to consumers. Nevertheless, this only adds to deflation arguments and puts the Federal Reserve in a very precarious position. With interest rates already historically low at 1.00 percent, the Fed has little room to maneuver from a monetary policy perspective.

Later this week, the US non-farm payrolls (NFPs) report is anticipated to show that the index fall negative for the tenth consecutive month in October, and the odds are looking in favor of a very disappointing reading given this morning's employment releases. First, Challenger Job Cuts surged 78.9 percent from a year earlier in October, marking the eighth straight month of growing job losses. Meanwhile, the ADP Net Employment Change plunged in October for the third consecutive month to match the November 2002 low of -157K. While these readings are not as bad as the levels we saw in mid-2001, they signal a clear deterioration in the labor markets that does not bode well for consumption trends going forward.

Carry Trades Slump on Lingering Risk Aversion, Pushing the Japanese Yen Higher

While Wednesday marked a relatively quiet day in the forex markets, this was not necessarily the case for other risky assets, as the DJIA and S&P 500 fell more than 5 percent while crude oil plunged over 7 percent. As usual, this worked to the benefit of the Japanese yen, which rose nearly 2 percent versus the euro and US dollar and jumped over 3 percent against the commodity dollars (Canadian dollar, Australian dollar, and New Zealand dollar). In the long term, I think there’s still quite a bit of bullish potential for the low-yielding yen. Keeping the inverse correlation between the US stock markets and Japanese yen in mind, we need to consider that while many governments have taken active steps to try to stabilize the financial markets, a global economic slowdown is bound to have a negative impact on corporate earnings going forward. As these figures are released, equity markets could fall even lower and take forex carry trades down with them. While I wouldn’t be surprised to see a bounce in these carry trades in coming weeks, the trend remains bearish and should ultimately continue to benefit the low-yielding Japanese yen.

Terri Belkas is a Currency Strategist at FXCM.