The Euro appears vulnerable ahead of the ECB policy announcement as the case for stimulus begins to look increasingly compelling.

Talking Points

• Euro Likely to Fall if ECB President Draghi Hints at Stimulus Ahead
• BOE Rate Decision Probably Another Non-Event as Inflation Spikes
• Japanese Yen Sinks, Aussie Soars as Chinese Exports Top Expectations

A monetary policy decision from the European Central Bank headlines the economic calendar in the hours ahead. Investors’ priced-in expectations and economists’ forecasts both suggest the central bank will keep the benchmark lending rate unchanged at 0.75 percent. This puts the focus on any guidance revealed by ECB President Mario Draghi in the press conference following the announcement.

The currency bloc’s economy shrank in three of the past four quarters, with the flat reading for the three months through March 2012 being the only exception. Composite PMI figures suggest another negative reading is likely to emerge for the fourth quarter of last year. Meanwhile, the inflation rate has trended downward since November 2011. Taken together, this seems to create an environment that both calls for and is able to support monetary easing.

The ECB had previously cited broken monetary policy transmission as the reason for holding off on stimulus, saying a rate cuts would be ineffective as swelling sovereign risk premiums pushed out borrowing costs. The announcement of the OMT program mid-year has clearly improved the situation, with key yields (most notably on benchmark Spanish and Italian 10-year bonds) now dramatically lower. This likely reflects the unwinding of tail risk and suggests the ECB now has room act.

Near-term correlation studies suggest the Euro is rather sensitive to front-end yields, meaning nod toward forthcoming accommodation emerging in Draghi’s press conference are likely to weigh on the single currency. Currencies sensitive to Eurozone growth like the Swedish Krona and the Norwegian Krone may rise however, and we remain short EURSEK. Such a scenario may also prove supportive for broader risk appetite considering the Euro-area recession remains a critical headwind for global recovery at large.

The Bank of England is likewise due to deliver its rate decision. Another non-event seems likely, with the MPC holding the key rate and the asset-purchase target unchanged. Inflation spiked worrying higher in the fourth quarter and leading economic data has performed mostly well relatively to expectations (according to data from Citigroup), suggesting a lack of urgency for the time being.

The Japanese Yen sank anew in overnight trade, down as much as 0.5 percent on average against its top counterparts as Asian stocks soared, sapping demand for the haven currency. The MSCI Asia Pacific benchmark equity index added 0.7 percent after China’s Trade Balance report showed exports soared 14.1 percent year-on-year in December, nearly tripling economists’ forecast for a 5 percent increase and buoying regional growth expectations. The Australian Dollar outperformed, adding as much as 0.6 percent against the majors.

Asia Session: What Happened

Euro Session: What to Expect

Critical Levels

--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

To contact Ilya, e-mail ispivak@dailyfx.com. Follow Ilya on Twitter at @IlyaSpivak

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