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EUR/USD: Trading the European Central Bank Interest Rate Decision

EUR/USD: Trading the European Central Bank Interest Rate Decision

2011-02-02 20:34:00
David Song, Currency Strategist
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Trading the News: European Central Bank Interest Rate Decision

Why Is This Event Important:

As market participants expect the European Central Bank to maintain its wait-and-see approach in February, we may see a muted reaction to the rate announcement, but comments from President Jean-Claude Trichet is likely to spark increased volatility in the exchange rate as investors weigh the prospects for future policy. However, as the EU Summit kicks off on Friday, the EUR/USD may hold a narrow range going into the end of the week, and fears surrounding the sovereign debt crisis may continue to bear down on the exchange rate as the risk for contagion intensifies.

What’s Expected:

Time of release: 02/03/2011 12:45 GMT, 7:45 EST

Primary Pair Impact : EURUSD

Expected: 1.00%

Previous: 1.00%

DailyFX Forecast: 1.00%

Will This Be Market Moving (Scenarios):

A Bloomberg News survey shows all of the 58 economists polled forecast the Governing Council to hold the benchmark interest rate at 1.00%, while investors are pricing a zero percent chance for a 25bp rate hike according to Credit Suisse overnight index swaps. However, we may see the ECB continue to strike a hawkish tone for future policy as inflation exceeds the 2% target for the second month in January, and the central bank head may attempt to talk down the risks for the region as European policy makers struggle to restore investor confidence.

The Upside

The CPI estimate for the Euro-Zone advanced to an annualized pace of 2.4% in January to mark the fastest pace of growth since October 2008, and inflation expectations may push higher over the coming months as households and businesses face rising energy costs. As the ECB maintains its one and only mandate to ensure price stability, the central bank may see scope to reestablish its exit strategy in the first-half of 2011, and hawkish comments following the rate decision could lead the EUR/USD to make a run at the 61.8% Fibonacci retracement from the 2009 high to the 2010 low around 1.3890-1.3900.

The Downside

However, as the European financial system remains weak, with the region facing an uneven recovery, the ECB could be forced to delay its exit strategy further as the governments operating under the fixed-exchange rate system struggle to manage their public finances. Accordingly, the ECB may retain a cautious tone for the real economy as the fundamental outlook remains clouded with uncertainties, and dovish comments from the central bank could lead the EUR/USD to retrace the advance from earlier this week as interest rate expectations falter.

How To Trade This Event Risk

As the ECB delivers its policy statement half an hour following its interest rate announcement, trading this event is certainly not as clear cut as some of our previous trades, but comments from the central bank could set the stage for a long euro trade as the central bank sees a growing risk for inflation. Therefore, if the ECB raises its outlook for price growth and sees scope to normalize monetary policy later this year, we will need a green, five-minute candle following the communiqué to establish a buy entry on two-lots of EUR/USD. Once these prerequisites are fulfilled, we will set the initial stop at the nearby swing low or a reasonable distance after taking market volatility into account, and this risk will generate our first target. The second objective will be based on discretion, and we will move the stop on the second lot to cost once the first trade reaches its mark in order to preserve our profits.

On the other hand, the ECB may continue to curb its outlook for future growth as the region copes with an uneven recovery, and the central bank may talk down the risks for inflation as the ongoing weakness within the economy dampens the risk for inflation. As a result, dovish comments following the rate decision is likely to bear down on the exchange rate, and we will implement the same strategy for a short euro-dollar trade as the long position laid out above, just in reverse.

Potential Price Targets For The Rate Decision

EURUSD_Trading_the_European_Central_Bank_Interest_Rate_Decision_body_ScreenShot015.png, EUR/USD: Trading the European Central Bank Interest Rate Decision

Impact that the ECB interest rate decision has had on EUR during the last meeting

Period

Data Released

Estimate

Actual

Pips Change

(1 Hour post event )

Pips Change

(End of Day post event)

Jan 2011

01/13/2011 12:45 GMT

1.00%

1.00%

+63

+184

January 2011 European Central Bank Rate Decision

The European Central Bank held the benchmark interest rate at 1.00% in January in order to stem the risk for contagion, and the central bank may continue to support the economy in 2011 as the region faces an uneven recovery. However, ECB President Jean-Claude Trichet struck a hawkish tone during the press conference following the rate announcement and said “inflation rates could temporarily increase further,” driven primarily by rising energy prices. The central bank head assured that inflation expectations remained “firmly anchored,” and reiterated that monetary policy remains “appropriate” as the economic outlook remains clouded with high uncertainty. Market participants showed a muted reaction to the rate announcement, but the EUR/USD surged higher following the comments from President Trichet as investors speculate the ECB to reestablish its exit strategy later this year.

EURUSD_Trading_the_European_Central_Bank_Interest_Rate_Decision_body_ScreenShot014.png, EUR/USD: Trading the European Central Bank Interest Rate Decision

Questions? Comments? Join us in the DailyFX Forum

Join Currency Analyst Michael Wright in the DailyFX Trading Room to Cover the Event LIVE!

View the Expo Presentation on ‘Trading the News’ For Additional Resources

To discuss this report contact David Song, Currency Analyst: instructor@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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