EUR/USD: Trading the European Central Bank Interest Rate Decision

Trading the News: European Central Bank Interest Rate Decision

What’s Expected
Time of release:        12/03/2009 12:45 GMT, 07:45 EST
Primary Pair Impact :    EURUSD
Expected:         1.00%   
Previous:         1.00%

Impact the European Central Bank Rate Decision has had on EURUSD over the last 2 meetings

November 2009 European Central Bank Rate Decision

The European Central Bank kept the benchmark interest rate unchanged at 1.00% in November as policy makers expect to see an “uneven” recovery, but went onto say that “not all our liquidity measures will be needed to the same extent as in the past” as the Governing Council sees the economy emerging from the recession. ECB President Trichet said that the emergency programs will be “phased out in a timely and gradual fashion” as the region returns to growth, but expects price pressures to remain subdued even as inflation is expected to turn positive over the “coming months.” At the same time, the central bank pledged “to counter effectively any threat to price stability over the medium to longer term” as the Governing Council maintains the 2% target for inflation however, market participants anticipate the ECB to keep rates on hold throughout the first half of 2010 as recovery remains weak.

October 2009 European Central Bank Rate Decision

The ECB held borrowing costs at the record-low in October and said that “the current rate remains appropriate” as the central bank aims to steer the economy out of its worst recession since the post-war period. At the same time, ECB President Trichet said “excess volatility and disorderly movements in the exchange rates have adverse implications for economic and financial stability,” and reiterated his support for a strong U.S. dollar as the global financial system remains fragile. Nevertheless, the central bank held a cautious outlook for future growth as policy makers anticipate the economy to recovery “at a gradual pace,” and went onto say that the rebound in economic activity is likely to be “uneven” as the government stimulus begins to taper off. In addition, the ECB expects price growth to remain “subdued” over the medium-term, and the board is likely to maintain its current policy in order to encourage a sustainable recovery.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario: If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the Euro against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on EURUSD ahead of the data release.

Bearish Scenario: If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the Euro against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on EURUSD ahead of the data release.

How To Trade This Event Risk

The euro is likely to face increased volatility over the next 24 hours of trading as the European Central Bank is scheduled to set monetary policy at 12:45 GMT on Thursday, and commentary following the rate decision could move the currency market as investors weigh the outlook for future policy. A Bloomberg News survey shows all of the 54 economists polled forecast the ECB to hold the benchmark interest rate at 1.00%, while investors are pricing a zero percent change for a rate hike, according to Credit Suisse overnight index swaps, and we may see muted price action immediately following the announcement as investors wait for the Q&A session with ECB President Trichet at 13:30GMT. Nevertheless, the Euro-Zone emerged from the recession in the third-quarter as economic activity expected 0.4% after contracting 0.2% during the three-months throughout June, and conditions are likely to improve going forward as the expansion in monetary and fiscal policy continues to support the real economy. However, a report by the European Union statistics office showed the headline reading for inflation slipped at an annual pace of 0.1% in October after contracting 0.3% in the previous month, while producer prices declined for the tenth consecutive month during the same period as firms continued to mark the longest slump since 2002, and price pressures are likely to remain subdued over the following year as policy makers expected to see a “gradual” economic recovery. However, ECB board member Michael Bonello expects  a “weak and protracted” recovery over the next two-years, driven by “credit constraints and reduced levels of consumption and investment,” and went onto say that “the required de-leveraging of balance sheets in the financial sector, along with excess capacity and unemployment heading for double digit levels, will continue to weigh on domestic demands” even as the economy returns to growth. Moreover, Governing Council member Ewald Nowotny said that the central bank will “keep an eye” on the foreign exchange market as the marked appreciation in the single-currency hampers the prospects for a sustainable recovery, while Jean-Claude Juncker, the President of the European Council, argued that the euro remained over-valued as the economic outlook for the region remains far from favorable. Nevertheless, as ECB President Trichet holds a dovish outlook for inflation and expects a gradual resumption of growth over the following year, the central bank is likely to hold borrowing costs at the record-low this month as growth prospects remain subdued. However, as the Governing Council conclude its easing cycle and plans to withdraw the emergency programs, hawkish language following the rate decision could renew expectations for higher interest rates as the central bank aims to normalize policy going forward.

Trading the given event risk may not be as clear cut as some of our previous trades as the ECB is widely anticipated to maintain its current policy but nevertheless, as the Governing Council looks to normalize policy in the year ahead, price action following the meeting could set the stage for a long euro trade. Therefore, if the central bank turns increasingly hawkish and holds an improved outlook for growth and inflation, we will look for a green, five-minute candle following the rate decision to confirm a buy entry on two-lots of EUR/USD. Once these conditions are met, we will set the initial stop at the nearby swing low, or a reasonable distance taking volatility into account, and this risk will establish our first target. Our second objective will be based on discretion, and we will move the stop on the second lot to breakeven once the first trade reaches its target in order to preserve our profits.

On the other hand, the slump in global trade paired with subdued inflation may lead the central bank to hold a dovish outlook for future policy, and market participants may continue to scale back expectations for higher interest rates as policy makers see a risk for a protracted recovery. As a result, if the ECB maintains its current policy and expects price pressures to remain weak throughout the following year, we will favor a bearish outlook for the single-currency, and will follow the same strategy for a short euro-dollar trade as the long position mentioned above, just in reverse.

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To discuss this report contact David Song, Currency Analyst: dsong@fxcm.com