Dovish Draghi To Keep ECB Rates On Hold - Now What?

by: Dean Popplewell

Will he or won't he? Most market analysts have already indicated that Draghi will keep benchmark ECB rates unchanged in a few hours, while at the same time the accompanying rhetoric will be of a "dovish" nature. That's the most prudent of choices, and this despite euro inflation numbers favoring an easing interest rate policy. Eurozone policymakers' actions are not generally of the "bold' type – they tend to be more conservative by nature.

Despite leaving its longest-ever recession in Q2, the eurozone's economy is again beginning to show several signs of fragility. Unemployment is at record high (+12.2%), while the demise of the U.S. dollar since July has seen the 17-member single currency appreciate almost +5% against its major peers this year. The currency's rise will eventually filter throughout the whole economic system, potentially curbing the competitiveness of euro exporters and depressing prices even further.

It’s the ECB's nature to formally wait for more data including its staff forecasts for growth and inflation, which are scheduled for publication in December before pulling any triggers – however, that's not to say that central bankers cannot surprise us. If the ECB does happen to do anything out of the ordinary this morning they would at least be bringing back some forex volatility, a variable that theses contained currency ranges have sorely been lacking of late. Deflation risk is complicating the region's recovery and the current deflation woes have prompted speculation that the ECB could invoke policies from a reduction in its benchmark lending rate (+0.5%), to adding fresh liquidity to the financial system, or broad-based asset purchases similar to those by the Bernanke's Fed. If this is to be the case – the market is not positioned for it.

Even for the contrarian and most pessimistic of traders there are signs that Europe's economy is strengthening. On the peripheries, Spanish industrial output (IP) grew in September – the first time in 30-months. For the Danes, not a eurozone member but experience a currency linkage to the EUR, their own IP grew +1.6% in September. Europe's grand leader, Germany, reported higher industrial order numbers yesterday.

Obviously there are a plethora of cons as mentioned above, Spanish unemployment remains at a record high, especially youth unemployment. Dutch inflation slowed last month, along with Austrian wholesale prices. Add in the eurozone's benign inflation numbers and it's no wonder that consensus is for Draghi and company to do very little except "pidgin talk." Draghi is required to at least keep the door ajar to the possibility of policy actions at next month's meeting.

The problem for the EUR is that there is ample room for the currency to fall much further as the heavy dose of "pro-euro positions" acquired this year is beginning to unwind. In the options market, the rising prices for EUR "puts" suggest that the single currency downfall could gather further momentum. Coupled with a less than dovish Fed and an ECB only getting more dovish suggests that the EUR could be persuaded to peek below 1.3350 sometime soon. U.S. yields are required to stable and support the USD. Through these levels, momentum could build even further opening up this year's lows below 1.28 again.

Across the English Channel, the relatively new kid on the block, Governor Carney at the Bank of England does not have an easy task. The U.K. economy remains on a "hot streak" with stronger U.K. data continuing to keep coming. This week alone, manufacturing, industrial and services beat consensus. The European commission has doubled its estimate for the U.K.'s economic growth for this year (+1.3%, y/y). Such predictions would make the U.K. the fastest growing of the main European economies.

Market consensus expects no rate change from the "Old Lady" (+0.5%) as capital markets are more interested in the November's inflation report, out on the 13th of this month. In its unemployment forecasts will lie the future of forward guidance, and therefore, policy settings. Investors are trying to figure out whether the U.K.'s QE is now officially buried? Currently, sterling remains invincible, plodding higher 1.6087, making any pullback that much harder in nature. A dollar reprieve may come from Governor Carney this morning. The market is definitely becoming more bearish sterling at outright lofty levels, but bullish GBP versus the EUR. This morning we get to see if those positions hold true.

Central banks are not the main feature this week – unemployment numbers holds that distinction, especially U.S. non-farm payrolls out tomorrow. The Aussie jobs report was surprisingly weak overnight. Australia’s employment rose by a marginal +1.1k last month versus a +10k consensus. Even the revisions disappointed. The bulk of the weakness was in full time employment, which fell -27.9k last month, while part-time employment rose +28.9k. The unemployment rate matched market expectations at +5.7%. If both the ECB and BoE do what's expected then market attention will shift quickly towards NFP's "dirty data" tomorrow. This may have U.S. enduring more screen watching, but it also gives one time to improve their Twitter (NYSE:TWTR) skills!

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