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How Did the Markets React? 

With a rate hike to 3.50 percent widely expected by the European Central Bank this morning at 12:45GMT, European markets have been acting very differently in anticipation of the rate increase, as well as in response to the potential aftermath. Fixed income, FX, and equity markets in the region showed clear trends during the last two weeks of November amidst a flurry of factors. First, there was a huge buildup of US dollar weakness which translated into euro strength. Additionally, staunchly hawkish ECB monetary policy committee members continued to talk up the need for “strong vigilance” on inflation, effectively preparing the markets for policy tightening in December. However, once the brunt of greenback weakness had resonated through the markets, traders appeared to have a change of heart as bunds, the euro, and the Xetra DAX index turned on their heels and started to reverse their prior trends. What will remain to be seen after the ECB’s rate decision and subsequent news conference by President Jean-Claude Trichet will be price action throughout Europe, as it will become clear whether this past week’s slow reversals were simply the result of market exhaustion or if traders are attempting to price in policy action (or the lack of) for 2007.

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.

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