Euro and British Pound Outlooks Hinge Upon ECB, BOE Rate Decision - What Will They Do?

European Central Bank - A record drop in Euro-zone CPI and rising unemployment leaves the odds in favor of rate cut by the European Central Bank on Thursday at 7:45 ET. In fact, Credit Suisse overnight index swaps are now fully pricing in a 50 basis point reduction by the ECB, and a 40 percent chance of an even more aggressive 75 basis point cut. Meanwhile, a Bloomberg News poll shows that economists expect the former. This easily leaves the decision as one of the most important pieces of event risk this week, but traders will also have to look out for comments by ECB President Jean-Claude Trichet during his post-meeting press conference. Mr. Trichet is one of the most opinionated central bank chiefs around, and suggestions that recession will last longer than previously expected in the Euro-zone has the potential to lead the euro far lower.

Bank of England - The British pound could pull back even further this week as Bloomberg News is forecasting that the Bank of England will cut rates by 100 basis points at 7:00 ET on Thursday. This is well within the realm of possibilities since the UK has already tipped into recession and the BOE thinks that things will only get worse. Monetary policy action will be just one of many efforts put forth in an attempt to prevent the UK economy from falling into a prolonged recession, as Chancellor of the Exchequer Alistair Darling downgraded growth forecasts during his pre-budget report on November 24 to 0.75 percent in 2008, between -0.75 and -1.25 percent in 2009, and between 1.5 to 2 percent in 2010. Chancellor Darling also announced a £20 billion fiscal stimulus plan, which calls for a cut to the Value Added Tax (VAT) to 15 percent from 17.5 percent, boosts to state pensions and child benefits, extensions of employment support, and a housing support package, among other things. Nevertheless, as we saw with the Australian dollar and the Reserve Bank of Australia’s larger than expected 100 basis point cut on Monday, a currency can actually gain if the central bank suggests in their policy statement that they will leave rates unchanged. As a result, traders should watch the BOE’s monetary policy statement closely.

US Dollar May Be Losing Steam Ahead of Friday’s US Non-Farm Payrolls (NFPs)

Despite an early morning rally, the US dollar eventually pulled back on a combination of building risk appetite and dour US economic data. As we said yesterday though, the US dollar remains within the range it has held to since the start of November, and for what it’s worth, day-to-day moves signal little more than consolidation. While it is possible that we will see a sharp correction lower in the near-term, the long-term trend remains very much in favor of US dollar strength.

Focusing on the data on hand, the ISM non-manufacturing index fell to a record low of 37.3 in November from 44.4, signaling the sharpest contraction in the services sector since record-keeping began in 1997. Nearly every other component hit their worst levels ever as well, including business activity, employment, prices paid, new orders, and new export orders. This is bearish for the US economy in many ways, as it suggests Q4 GDP could contract following the 0.5 percent drop in Q3, and also indicates that the release of Friday’s US non-farm payrolls and unemployment rate could be deeply disappointing. In fact, NFPs are already forecasted to fall by 330k, surpassing the 2001 low of -325k. Watch for our NFP outlook on Thursday for more on this topic and how the US dollar may respond.

New Zealand Dollar Holds Up Despite the RBNZ’s Aggressive 150bp Rate Cut

Like the Australian dollar on Monday, the New Zealand dollar edged lower, but subsequently rebounded despite the fact the Reserve Bank of New Zealand slashed rates by 150bps to a five-year low of 5.00 percent. This is the fourth time the RBNZ has cut rates in so many meetings, and each has been more aggressive than the last. After the announcement, RBNZ Governor Alan Bollard said in a statement that the sharp reduction was necessary as the economies of New Zealand’s trading partners were expected to “contract or grow only very slowly over the next few quarters.” While Mr. Bollard left the door open for further rate cuts, he also said that “domestically generated inflation” remains “stubbornly high,” and that monetary policy is in an “expansionary position.” That said, NZD/USD remains contained within a tight range of 0.5260-0.5340, and if risk appetite continues to improve, the pair could easily rally above the top of the range.

Terri Belkas is a Currency Strategist at FXCM.