Euro Weaker Or Much Weaker Post ECB

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 |  Includes: FXE, UDN, UUP
by: Tim Clayton

The most likely outcome is that the ECB will resist an interest rate cut at Thursday's meeting and adopt a generally dovish tone regarding growth and inflation. This would provide some relief for the economy while maintaining pressure on national governments, and also have some beneficial impact in dampening euro demand. Structural and cyclical developments are likely to trigger further U.S. dollar outperformance, and an unchanged ECB policy would weaken the euro slightly.

There is a significant possibility that the ECB will take a more aggressive tone and sanction a cut in the main refinancing rate, or even consider the extremely radical policy option of a move to negative deposit rates. In the scenario of negative deposit rates, the euro would be likely to weaken very sharply towards 1.25 against the dollar.

The latest staff projections on the eurozone economy will be made available for March's council meeting. These are likely to provide the framework to justify fresh policy action with lower inflation and a further downgrading of growth forecasts for 2013 and 2014.

There is no prospect of the peripheral economies registering the kind of growth necessary to lower the unemployment rate and ease social tensions. Overall, at the eurozone level, it will be possible to justify an easing of policy.

The bank will inevitably be constrained by political considerations, as sequencing has been a clear demand form the bank. This is one reason why the Italian political stalemate is so dangerous, as it will lead to a crucial period of inaction and back-tracking on reforms.

The ECB will continue to insist that national governments take the necessary action to improve the economic outlook, and again forcefully state that it cannot solve structural issues. There will, therefore, be a very powerful sense of inertia within the bank, as it wants politicians at national and supra-national level to take action first. There will, therefore, be major reluctance to take radical policy action until necessary political and economic commitments are in place.

The bank will also face the threat of growing internal divisions given the divergence in economic outlooks. If, however, the ECB fails to act, it could quickly find itself engulfed in the next phase of the eurozone crisis.

A feature of ECB head Draghi has been his willingness to embrace new thinking and contemplate unorthodox policies such as the LTRO, and there has also been evidence of more flexible thinking. Draghi will be extremely aware of the dangers of keeping policy too tight, and there is little to lose from a dovish tone.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.