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The European Central Bank (ECB) will meet on Thursday and investor expectations for an interest rate cut are growing. The euro (NYSEARCA:FXE) was weak on this speculation, though European bond and equity markets rallied. The ECB is falling behind the Federal Reserve and the Bank of Japan in terms of aggressive monetary policy, so the impact of a rate cut on the euro may be limited. It would, however, be a positive signal for the European equity markets. In this article I will discuss the upcoming ECB rate cut decision and analyze the euro and other European asset classes.

To Cut Or Not And The Impact On The Euro

Expectations for a rate cut have been growing because economic data from the eurozone continues to be weak. However, unlike the Federal Reserve, the ECB has been very hesitant to use monetary policy to try and help the economy (I wrote about this in more detail here: Europe Is Calm...).

The falling inflation rate is making it easier for the ECB to cut rates.

(click to enlarge)

(Source: ECB.int)

Following the last ECB meeting, Mario Draghi commented about inflation:

According to Eurostat's flash estimate, euro area annual HICP inflation was 1.7% in March 2013, down from 1.8% in February. The ongoing decline in annual inflation rates mainly reflects the energy component of the price index. Looking ahead, price developments over the medium term should remain contained in an environment of weak economic activity in the euro area. Inflation expectations are firmly anchored and in line with price stability over the medium to long term. (Source: ECB.int)

The ongoing decline in the commodity markets is providing downward pressure on inflation. Furthermore, high unemployment across the eurozone is keeping down wage inflation. The inflation level has not yet dropped to uncomfortable levels, but the momentum is pointing to lower inflation.

A rate cut, should it come, would probably have little impact on the European economy, but could cause some short-term weakness for the euro. European equity markets may continue to rally on the news of lower rates, especially the banks.

From a big picture perspective, the ECB's rate cut may not matter so much. The Federal Reserve is engaged in QE-Infinity and is buying $85 billion of bonds on a monthly basis and there is no end in sight. Also, the Bank of Japan recently embarked on a huge quantitative easing program. Compared to these programs, an ECB rate cut looks rather tame.

Euro Price Action

The euro is still trading above the levels from the Cyprus crisis a few weeks ago, despite the mild weakness.

The euro's current price is in the middle of the 20, 50, 100 and 200 day moving averages. There is a lot of indecision about the euro's direction as the average prices over these time frames are basically the same. It will be interesting to see if the ECB's rate decision will be the start of a big move or if the euro will trade sideways while the Japanese yen makes the big moves in the currency markets.

(click to enlarge)

(Source: FreeStockCharts.com)

European Sovereign Bonds

The speculation about an ECB rate cut was a positive catalyst for European sovereign bonds. These bonds have also benefited from global liquidity and the search for yield, thanks, in part, to the Bank of Japan QE program.

European bonds rallied across the board and the spreads of the peripheral countries continued to compress. Astonishingly, the Italian 10 year closed the week at 4.06% and the Italy-Germany spread continued its move below 300 bps.

(click to enlarge)

The euro would likely benefit if global benefits continue to invest in European bonds as they search for yield.

European Equity Markets

The European equity markets also rallied on the speculation about an ECB rate cut. Interestingly, the German index led the week.

The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI Italy Index Fund (NYSEARCA:EWI), and iShares MSCI Spain Capped Index Fund (NYSEARCA:EWP), and the SPDR EURO STOXX 50 ETF (NYSEARCA:FEZ).

EWG Chart

EWG data by YCharts

The Financial sector was strong and outpaced the broader market.

The following compares the iShares MSCI Europe Financials ETF (NASDAQ:EUFN) with the iShares MSCI EMU ETF (NYSEARCA:EZU).

EUFN Chart

EUFN data by YCharts

I finally invested in Banco Santander (NYSE:SAN) last week after watching it for a while. Banco Santander reported earnings that were below analyst expectations and the stock sold off at the end of the week.

I may increase my position on further weakness.

SAN Chart

SAN data by YCharts

(click to enlarge) (Source: FreeStockCharts.com)

Impact of European Equity Markets on U.S. Equity Markets

On a trailing 3 month basis, the divergence between the U.S. and European equity markets is compressing, as the European markets trade up. It does not appear that the European markets will drag down the U.S. markets like last summer.

The following compares the S&P 500 (NYSEARCA:SPY) and the Financial Select Sector SPDR ETF (NYSEARCA:XLF) with their European counterparts, the EZU ETF and the EUFN ETF.

SPY Chart

SPY data by YCharts

Conclusions

Speculation about an ECB rate cut was the big news in Europe last week. The euro traded down and the European bond and equity markets rallied. A rate cut by the ECB would likely have little impact on the European economy.

In the short term, it may be a negative for the euro, but the ECB is much less aggressive with monetary policy than the Federal Reserve or the Bank of Japan, so the impact on the euro may be limited. However, a rate cut would be a good signal to the equity markets.

The euro and European assets have performed well since the Cyprus crisis. Last week, I established a position in Banco Santander to increase my European exposure and may seek to increase it further after the ECB's decision on interest rates.

I am not making a prediction about the ECB's rate cut decision, but will look for more opportunities afterward.

Source: ECB Decision On Interest Rates And The Impact On The Euro

Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.

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