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European Central Bank Rate Decision (Thursday, 12:45GMT; 7:45EST)

Consensus:          3.50%

Previous:               3.50%

How Will the Markets React? 

European markets are clearly confounded about what to expect from not only the European Central Bank’s interest rate decision, but from the notoriously transparent ECB President Jean-Claude Trichet as well, who is scheduled to speak in a press conference at 13:30GMT on Thursday. As a result, there is significant event risk for the Euro and German bund yields. The currency’s apprehension is especially palpable, as the EUR/USD has hovered just above the 1.2900 level for the past few weeks, with price swings moving on shifting sentiment in both the Euro-zone and US. Predictions unanimously favor unchanged rates through the week’s end, with a Bloomberg News poll showing that 48 of 48 respondents expect no hike. Recent data supports the central bank’s wait-and-see approach, as inflation reports have been softer than expected. The CPI estimate for January was predicted to jump above the ECB’s limit for price stability to 2.1 percent. However, the figure came in unchanged from December at 1.9 percent. Additionally, concerns have started to materialize regarding the impact ofGermany’s VAT hike to 19 percent from 16 percent on the Euro-zone economy, as consumer confidence surprisingly fell in January to -7 from -6. Furthermore, the retail sector has shown signs of faltering with the Purchasing Managers’ Index plunging below the 50 boom/bust level to 47.9 and retail sales rising a weaker-than-expected 0.3 percent in December. Nevertheless, worries regarding the second-round effects of previous oil price increases remain a primary concern of the ECB and should keep Mr. Trichet touting a hawkish stance.

Bonds – German 10-Year Bunds

European bond yields continue to reflect expectations of higher rates through the medium term, with the 10-year bunds offering 4.031 percent during early afternoon trade in Europe. Bund yields have been gaining steadily since the beginning of December, when the European Central Bank raised rates 25 basis points to 3.50 percent. Additionally, staunchly hawkish commentary by President Jean-Claude Trichet during the subsequent press conference left markets anticipating the potential for two rate hikes in February and March. Since then, economic data has been a bit more tepid, leading estimates for monetary policy tightening deferred until March.

FX – EUR/USD

EUR/USD has declined more than 400 points since the European Central Bank’s December hike to 3.50 percent. With an impending ECB decision looming on Thursday, forex traders have kept Euro bid just above the 1.2900 level, despite recent weakness in economic indicators out of the Euro-zone. While the data hasn’t changed substantially since mid-January, commentary from monetary policy officials have been more than enough to keep Euro bulls in the market. Indeed, rumors that the ECB is not happy about last week's MNI report alleging the central bank was considering pausing its tightening cycle following a March rate hike has propelled EUR/USD from the 1.2915 level towards 1.3000. ECB President Jean-Claude has been eager in the past to correctly steer market expectations, so if there is a chance of further hikes beyond March, the central bank will not want markets to totally dismiss the possibility of further moves. Such a tightening bias and the return of the key phrase “strong vigilance” could easily send Euro spiking higher towards the early January highs near 1.3300 – at least temporarily (as higher rates have likely already been priced in). However, should the ECB communiqué disappoint the markets and slash rate expectations, 1.2900 could easily be lost. For more on how to trade the ECB’s decision, see Boris Schlossberg’s special report: http://www.dailyfx.com/story/special_report/special_reports/ECB_Rate_Decision__For_February_1170837332534.html.

Another factor for traders to keep in mind is the Bank of England’s decision scheduled for the same day. The central bank’s surprise hike in January and extreme inflation concerns made waves throughout the currency markets. Should the BOE’s bias be swayed and lead to more surprising monetary policy action, EUR/GBP price action could easily feed into the EUR/USD pair. For more on the BOE’s policy meeting, see Tuesday’s DailyFX Cross Markets piece by David Rodriguez and John Kicklighter: http://www.dailyfx.com/story/dailyfx_reports/cross_markets_data_reaction/Bank_of_England_Decision_Leaves_1170808604592.html

Equities – Xetra DAX Index

Solid earnings reports and optimistic investor sentiment have propelled shares in German equities to six year highs over the past five months, as overnight lending rates seem to be far from equity traders’ minds. Despite the fact the ECB will be announcing their interest rate decision and President Jean-Claude Trichet is expected to come out swinging with hawkish rhetoric, Frankfurt’s Xetra DAX index has steamed ahead 0.4 percent to 6,901.18 in afternoon European trading. Shares of stocks in companies like Infineon, the German chipmaker, gained 4.6 percent today alone to 11.30 euros after announcing it had won a deal with Nokia to supply the Finnish mobile handset maker with chips for its lower-cost phones.

Typically, equity traders show a less than enthusiastic attitude towards interest rate hikes, as the burden to borrowers diminishes profit prospects for firms. As a result, a surprise hike or signals of highly aggressive tightening plans by the ECB could lead to a sharp decline in equities. On the flip side, should the central bank show a remotely dovish side, shares could see a rally. Nevertheless, any reaction seen by equity traders will likely be temporary, as prices in the European stock markets remains on a clear uptrend.