Euro Eases Ahead of ECB Decision

Bonds – German 10-Year Bunds

Prices on German 10-year bunds worked their way to a high of 1.840 over the course of the last two weeks of November, which was in line with Treasury gains in the US via flight to safety on the rapidly depreciating dollar. Additionally, the increases in bund prices were typical in reaction to declining share prices (see Equities section). However, after bunds peaked this past Monday morning, prices eased lower, sending yields back up to 3.676 percent just ahead of the widely expected rate hike today. Should the central bank signal an extended pause on monetary policy action, the recent shift towards lower price may create a buying opportunity on bunds. On the flip side, if Mr. Trichet and the ECB’s policy statement continue to signal a hawkish stance, bunds could precipitate down towards 100.00.

FX – EUR/USD

Over the past three weeks, the euro has been a huge beneficiary of the greenback’s collapse and has appreciated to 19-month highs of 1.3370. Working in the EUR/USD pair’s favor was hawkish rhetoric by various ECB council members, including President Jean-Claude Trichet, who have cited the need for “strong vigilance” on inflation. This phrase has basically become the ECB’s code word for an upcoming rate hike, which the markets widely expect to occur this morning. However, since the euro’s peak at 1.3370, price has eased lower as traders realize that the increase in ECB rates may be more than priced in. Furthermore, with European economic and consumer price growth slowing, 3.50 percent could be the end of the line for at least a few months. As a result, the monetary policy statement and Mr. Trichet’s commentary at today’s news conference (starting at 13:30GMT) will be a make-or-break event for EUR/USD. If markets foresee a strong potential for continued policy tightening, EUR/USD has a change of holding above 1.3000 for some time. Conversely, ECB downgrades to expansion or inflation could lead to more neutral rate expectations, and subsequent euro fallout.

Equities – Xetra DAX Index

The last two weeks of November saw the German benchmark index, the Xetra DAX, steadily decline to a low of 6195.81 as a stronger euro hurt prospects for companies in the export sector. Additionally, the move in equities was typical ahead of a rate hike. Although an increase in rates infers a healthy, strong economy, it also means that businesses will incur higher borrowing costs and a potential slowdown in consumer spending.

Similar to the fixed income and FX markets, equities turned at extreme price levels (at the 12/1 low) and retraced higher. The banking sector helped carry the DAX back up to 6380.60 ahead of the ECB’s expected hike, as higher rates help to improve profit margins for banks. Also similar to the other European markets, the ECB’s policy statement and commentary by Mr. Trichet at the subsequent news conference may be crucial to share price action. The outlook for economic expansion will likely be the trigger, as improved GDP projections boost profit potential for domestic companies. However, downgrades to growth could find the DAX returning to the previous downtrend.