Central Bank Watch: Euro Awaits Key ECB Policy Decision for Guidance

Market interest rate expectations have deteriorated across the board with no hikes expected in the near future from any of the major central banks. European sovereign debt troubles have led to central bankers taking a cautious wait-and-see approach to monetary policy as 2010 comes to an end. Taking a look at next year, market expectations are highest in the commodity bloc. Canada leads the way with 63 basis points of hikes expected, followed by New Zealand at 59bp and Australia at 20bp. These are not robust expectations by any means but are bound to change with economic circumstances.

Turning to the European Central Bank’s policy decision later today, the consensus is obviously for no change to benchmark interest rates. Even so, this is one of the most anticipated decisions in recent months as markets eagerly await the central bank’s response to the turmoil that has been taking place in European sovereign debt markets. The bailout of Ireland has not quelled fears that many of the region’s governments may be overburdened with debt. We’ve seen signs of contagion into Portugal, Spain, and even Belgium, with yield spreads versus relatively safe German bunds hitting the highest levels on record in many cases.

Earlier this week, ECB President Jean-Claude Trichet remarked that markets “are tending to underestimate the determination of governments [to stabilize the situation].” Trichet’s comments have sparked speculation that the central bank may take action. One possibility is that the ECB delays terminating the unconventional monetary policy measures-- such as unlimited liquidity to banks-- that it introduced to combat the credit crisis two years ago. Given that the bank has repeatedly indicated that it would be rolling back these programs, this would be quite a turn of events. Some are even speculating that the ECB may substantially increase its government bond buying program. Recall that this program was introduced back in May during the first phase of the sovereign debt crisis that revolved around Greece. The central bank bought 60 billion euros worth of bonds at the time, but the door remains open for further purchases. Indeed, in November the ECB bought almost 4 billion euros worth of bonds, the most since July.

While an easing of monetary conditions is typically a negative factor for a currency all else equal, in this case, were the ECB to take decisive action, it is not necessarily a negative for the Euro. Any potential reduction in systemic risk, for example, would serve as a positive offset, and the two factors must be weighed against each other.