FOREX: Euro Response to ECB Rate Cut May Wait for EU Summit Outcome

Talking Points

• Spotlight Turns to Brussels as Critical EU Leaders’ Summit Begins
• FX Market Reaction May Prove Muted as ECB Cuts Interest Rates
• Bank of England Policy Announcement Likely Another Non-Event
• Australian Dollar Slumps After Disappointing Employment Figures
• NZ Dollar Outperforms as RBNZ Plays Down Rate Cut Prospects

Most major currencies were confirmed to narrow ranges against the US Dollar (ticker: USDollar) in overnight trade as FX markets braced for the EU leaders’ summit set to begin tonight. The Australian Dollar underperformed, sliding as much as 0.5 percent on average against its leading counterparts, following a disappointing set of employment figures. The economy unexpectedly lost a net 6,300 jobs in November and the unemployment rate rose to 5.3 percent. Meanwhile, the New Zealand Dollar pushed broadly higher after the RBNZ kept monetary policy on hold and gave no indication of forthcoming interest rate cuts. RBNZ governor Alan Bollard said the recent depreciation of the currency was already providing some support while repairs in Canterbury (following the Christchurch earthquakes) will offer a “significant boost to demand for an extended period.”

Needless to say, the Eurozone debt crisis is in the spotlight over the coming 24 hours as European Union leaders gather in Brussels for a summit that investors hope will finally deliver a truly comprehensive plan to contain sovereign risk and avert a meltdown of the currency bloc. Investors will be looking for the EU to outline concrete plans for fiscal integration within the Eurozone, which they hope will give the European Central Bank the necessary cover to step up ramp up sovereign bond purchases and force down regional borrowing costs, thereby averting a catastrophic default in a large member state like Italy or Spain. Hints of such an arrangement emerged in comments from ECB President Mario Draghi late last week. Broadly speaking, a positive outcome requires an arrangement with minimal changes to existing EU treaties - speeding along its implementation - and a detailed roadmap for fiscal union with comprehensive steps to assure member states maintain budgetary discipline going forward. As we discussed yesterday, a disappointing outcome seems likely.

Separately, the monthly ECB interest rate decision is widely expected to yield another 25bps reduction in the headline lending rate, bringing it down to 1 percent. Additional liquidity provisions such as extending LTRO maturities past 1 year or broadening acceptable collateral criteria for loans from the central bank may also emerge, although the larger issue of sovereign bond purchases will naturally wait until after the EU summit. It is unclear whether the rate cut will prove supportive for the Euro in that it helps counter the debt crisis or detrimental in that it reduces the yield-seekingappeal the single currency. Whatever the outcome however, the market’s reaction is likely to be muted until after the result of the region leaders’ sit-down is unveiled. Elsewhere, the Bank of England rate decision is expected to offer no changes in the policy mix and consequently no statement from Mervyn King and company, meaning traders will have to wait for the MPC minutes release due in 2 weeks to update expectations.

Asia Session: What Happened

Euro Session: What to Expect

Critical Levels

--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

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