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:        03/04/2010 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

February 2010 European Central Bank Rate Decision

Euro-Zone’s central bank held borrowing costs steady at 1.00% in February, with ECB President Trichet reiterating that interest rates remain appropriate as policy makers expect price pressures to remain subdued throughout the year. Moreover, Mr. Trichet stated that the board will continue to support “the banking system, while taking into account the ongoing improvement in financial market conditions,” and went onto say that the emergency measures will be unwound “when necessary” as the board aims to encourage a sustainable recovery. As a result, the ECB is likely to maintain a neutral policy throughout the first-half of 2010, and increased turmoil in the economies operating under the single-currency may lead the central bank to extend its unprecedented measures as the Governing Council expects to see an “uneven” recovery this year.

January 2010 European Central Bank Rate Decision

The European Central Bank left its key benchmark interest rate unchanged at 1.00%  in January as expected as central bank president Trichet said that policy makers are doing all that they can to spur economic growth, while also signaling that officials will wait for more signs of economic recovery before withdrawing further emergency support. At the same time, the ECB president stated that certain principles must be respected on banker pay so institutions are able to lend,  and went onto add that “we’re not losing sight of our medium-term mandate: to deliver price stability.” Meanwhile, during the question and answer segment, Trichet publicized that “we [the central bank] will not change our collateral framework for the sake of any particular country.” Investors are pricing in zero percent probability that policy makers will raise rates at its policy meeting on February 4th according to the Credit Suisse overnight index swaps.

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 European Central Bank is widely expected to hold the benchmark interest rate at 1.00% on Thursday as the Governing Council continue to see a risk for an “uneven” recovery, and commentary following the rate decision is likely to spark increased volatility in the exchange rate as investors weigh the outlook for future policy. A Bloomberg News survey shows all of the 52 economists polled forecast the central bank to keep borrowing costs at the record-low, while Credit Suisse overnight index swaps illustrates investors are pricing a zero percent chance for a rate hike this month as policy makers expect inflation to remain subdued throughout the year. A report by the European Union showed the core rate of inflation weakened to an annualize pace of 0.9% in January to mark the lowest level of price growth on record, while the CPI estimate slipped to 0.9% in February, and the central bank is likely to hold a dovish policy stance over the coming months as they maintain their one and only mandate to ensure price stability. Moreover, the EU maintained its economic forecast for the region and projects GDP to expand at an annualized pace of 0.7% this year, while inflation is expected to average 1.1% as the recovery remains “fragile.”

Nevertheless, ECB President Jean-Claude Trichet has repeatedly said that not all of the emergency measures will be needed, and noted that the Governing Council will decide on the pace of normalizing policy at this month’s meeting as economic and financial conditions improve. As a result, commentary following the rate decision is likely to spark increased volatility in the exchange rate, and remarks that would highlight a willingness to hike rates later this year is likely to spur a rise in interest rate expectations as Mr. Trichet pledges to “counter effectively any threat to price stability over the medium to longer term.” However, the central bank argued that “high levels of public deficits and debt place an additional burden on monetary policy” in its monthly report, and we may see the central bank maintain a neutral policy stance this month as the central bank aim to balance the risks for the economies operating under the single-currency.

As the ECB is anticipated to maintain its current policy this month, trading the rate decision is certainly not as clear cut as some of our previous trades but nevertheless, price action following the meeting could set the stage for a bullish euro trade as the central bank aims to normalize policy this year. Therefore, if we hear any commentary that foreshadows a likelihood for a rate hike later this year, we will need to see a green, five-minute candle following the rate decision to confirm a buy entry on two-lots of EUR/USD. Once these conditions are fulfilled, we will set the initial stop at the nearby swing low or a reasonable distance, and this risk will establish our first objective. Our second target will be based on discretion, and we will move the stop on the second lot to cost once the first trade reaches its mark in an effort to lock-in our profits.

On the other hand, subdued price growth paired with the deterioration in public finances could lead the ECB to hold a cautious outlook for the region, and dovish commentary following the rate decision is likely to weigh on the exchange rate as investors scale back expectations for a rate hike. As a result, if the Governing Council sees scope to keep rates steady throughout the rest of the year, we will favor a bearish outlook for the single-currency, and will implement the same strategy for a short euro-dollar trade as the long position laid out above, just in reverse.

Questions? Comments? Join us in the DailyFX Forum

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