The European Central Bank’s monetary policy announcement on Thursday is one the most important event risks this week. While we do not expect the central bank to cut interest rates, we believe ECB Governor Mario Draghi will prepare the market for lower rates in December. If we are right, ECB dovishness should be enough to drive EUR/USD to a fresh 6 week low.

With consumer price growth slowing and producer prices in negative territory, deflation is becoming a growing risk for the Eurozone. Policymakers in Europe are pressured to act because they do not want Europe to become the next Japan. Over the past few decades, we have seen how messy deflation can be and how difficult it is to reverse if it becomes entrenched. Rising unemployment and sluggish growth has made it very difficult for businesses to raise prices and unless the labor market improves quickly, we may not see much upside in price pressures.

Currently, CPI in the euro area is growing at its slowest pace in almost 4 years. According to estimates from the European Union’s statistics office, the annualized rate of inflation dropped to 0.7% in October from 1.1% in September. The annualized rate of producer price growth is -0.9%. Considering that the ECB’s target is 2% inflation, the drop in price growth will pressure the central bank to ease. Europe could certainly use another dose of stimulus. Although the recession officially ended in the region, growth has been very weak, particularly in the peripheral economies, making deflation a serious problem in that part of the region. As we saw this morning, consumer spending is also a problem and unfortunately that weakness has extended beyond the periphery into the core economies (Germany and France). If not for the upward revision in PMI services, the ECB may consider a rate cut tomorrow more seriously.

Why is December a Prime Time for a Rate Cut?

However we expect the ECB to wait until December to cut interest rates. The central bank likes to prepare the market for major changes in monetary policy and given that only 3 out of the 70 economists surveyed by Bloomberg expect a rate cut tomorrow, the market is clearly not positioned for a move. By setting expectations for lower rates on Thursday, the ECB will give investors plenty of time to discount the move, so that hopefully it will lead to only a mild reaction in the EUR/USD when the change is actually made. The central bank will also be releasing its staff forecasts in December. A lot of work is put into these projections and many policymakers will want to wait to see the outcome of the exercise before deciding to change monetary policy. A rate cut is needed sooner or later because bringing inflation from its current levels back up to 2% won’t be easy without looser monetary policy. The first step is to boost growth and a rate cut followed by another LTRO next year will go a long way in achieving that goal.

What Does this Mean for Euro?

The prospect of easier monetary policy in the Eurozone alone is negative for the euro but when combined with the prospect of less stimulus from the Federal Reserve, we could see a far more significant sell-off in the currency. The current support level in the EUR/USD is 1.3480, the 38.2% Fibonnaci retracement 2008 to 2010 sell-off and then the 6 week low of 1.3440 but dovishness by the ECB should be enough to drive the currency pair to 1.34 which should only be short term support for the pair. The more significant support level is down at the 200-day SMA near 1.32.

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