special reports

EURUSD - Trading the ECB Interest Rate Decision

Wednesday, 03 December 2008 12:17:51 GMT  |  David Song, Currency Analyst

The European Central Bank is widely expected to lower the benchmark interest rate by 50bp to 2.75% as price pressures cool. Falling commodity prices have certainly helped to eliminate the upside risks for inflation, and should allow the central bank to ease policy further as they carry out their one and only mandate to ensure price stability.

Trading the News: European Central Bank Rate Decision

What’s Expected

Time of release:                  12/04/2008 12:45 GMT, 07:45 EST

Primary Pair Impact :          EURUSD

Expected:                              2.75%

Previous:                               3.25%

Impact of the ECB rate decision on EURUSD over the last 3 months

November 2008 ECB Rate Decision

The European Central Bank lowered the benchmark interest rate by 50bp to 3.25% from 3.75% following the coordinated rate cut on October 8th. The ECB, along with the Fed, lowered the key rate by 50bp to 3.75% from 4.25% in order to avoid a global meltdown. Meanwhile, falling oil prices have certainly helped to taper the upside risks for inflation,  which would allow the central bank to hold a dovish outlook going forward. ECB President Trichet explicitly stated that policymakers may lower the benchmark interest rate further as they expected economic activity to remain subdued for ‘a rather protracted period’ of time, and may continue to ease policy throughout the next year as the economy heads into a recession. The remarkable shift in policy has clearly weighed on the euro, and may weaken further against the U.S. dollar as investors curb their appetite for risk.

 

October 2008 ECB Rate Decision

ECB policy members held the benchmark interest rate steady at 4.25% despite the downturn in the global financial market. The central bank was widely expected to hold a neutral policy stance as inflation remains well above their desired target, but could be forced to lower borrowing costs over the coming months as the spillover effects of the credit crunch spreads throughout the global economy. Increased turmoil in the financial sector has already led governments throughout Europe to step in as the lender of last resort, and policy makers may opt to take additional steps to avoid a severe downturn in the economy. Moreover, falling commodity prices should help to lower prices pressures in the near-term, which should allow the ECB to push inflationary concerns to the backburner as fears of a recession intensify.

 

September 2008 ECB Rate Decision

The ECB held a neutral policy stance to leave their benchmark interest unchanged at 4.25%, stating that upside inflation risks remains highly uncertain going forward. The central bank noted that they may look to increase the interest rate in order to anchor inflation expectations, and went onto say that the bank is ready to take the necessary steps if upward wage pressures accelerate in the following months. Amid the hawkish rhetoric, the growth outlook for the 15 European nations has deteriorated considerably since the beginning of the year, and has fueled recessionary concerns for the economy record high borrowing costs continues to limit economic activity. As the central bank remains focused on upside prices pressures, economic growth could weaken further as many countries throughout Europe are on the brink of a cession.

How To Trade This Event Risk

 

The European Central Bank is widely expected to lower the benchmark interest rate by 50bp to 2.75% from 3.25% as price pressures alleviate. Falling commodity prices have certainly helped to taper the upside risks for inflation, which should allow the central bank to ease policy further as they carry out their one and only mandate to ensure price stability. A Bloomberg News survey showed that 36 of the 56 economists polled expect the ECB to deliver a 50bp cut, while others estimate the interest rate to fall as low as 2.25%. With oil prices holding below $50 a barrel, policymakers lowered their outlook for inflation as they expect the CPI to fall to 2.1% from a previous estimate of 3.2% in October. Moreover, the producer price index recorded its biggest decline in 22 years as the annual rate slipped to 6.3% from 7.9% in September. Meanwhile, mounting growth concerns paired with instability in the credit markets have certainly dragged on the economy as retail spending fell 0.8% in October despite expectations for a 0.4% decline, and growth prospects for the euro-region may deteriorate further over the coming months as the economy heads into a recession. ECB President Trichet said that economic activity may remain subdued for a ‘protracted period’ of time as the spillover effects of the credit crunch continues to take a toll on the real economy, and lowered the growth forecast to 0.1% for 2009. Deteriorating fundamentals continues to fuel expectations for the central bank to lower borrowing costs throughout the next year as investors anticipate the central bank to lower the key interest rate by at least 125bp over the next 12 months, which could stoke increased selling pressures for the euro going forward.

 

As market participants raise bets for an ECB rate cut, we would need a drastic shift in the policy outlook paired with neutral commentary following the rate decision to set the stage for a long euro trade. With our expectations in hand, we will look for a green, five-minute candle following the release to validate a long entry on two lots of EURUSD. Our initial stop will be placed at the nearby swing low (or reasonable distance depending on volatility), and this risk will determine out first target. Our second target will be based purely on our discretion, and in order to preserve our profits, we will move the second lot to breakeven once the first trade reaches its target.

 

On the other hand, mounting growth fears paired with easing price pressures should allow the ECB to lower borrowing costs further, which could stoke increased selling pressures for the euro. As a result, if the central bank cuts 50bp or more, we will favor a short euro trade, and  will follow the same set up as the long trade mentioned above, just in reverse.

 

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