It may be a holiday week in the U.S., but with 2 major central banks expected to ease monetary policy on Thursday and the U.S. non-farm payrolls report scheduled for Friday, we should see a pickup in volatility over the next 48 hours. Having left interest rates unchanged at 1% since the beginning of the year, the European Central Bank is now expected to cut interest rates by 25bp to 0.75%. Although the ECB has not dropped hints about their inclination to ease, 82% of the economists surveyed by Bloomberg expect the central bank to cut interest rates. Considering that the news agency surveyed 62 analysts, this is not a small amount. The main reason why the ECB is expected to ease is growth. While the financial markets have stabilized and Spanish and Italian bond yields declined, economic data has taken a turn for the worse. The commitment to austerity in Europe poses a major threat to growth in the second half of the year and if European policymakers want to avoid a deeper recession, monetary stimulus is needed to support the economy.
While we agree that the ECB needs to ease, President Draghi has shown very little indication of his plans to do so and has preferred to keep pressure on European leaders by holding off further measures. The main question for Draghi tomorrow is whether EU Leaders deserve to be rewarded for the banking union or punished for not making progress on a fiscal union. When the ECB last met, Draghi left monetary policy unchanged and said there is only so much a central bank can do. For the past few months, he has held back monetary stimulus to pressure European Leaders into action and based on his comments following the EU Summit, he is pleased with their results. Draghi said EU Leaders made good decisions, delivered tangible results and took a courageous leap of political imagination. Preparing the market for an interest rate cut before it happens is the traditional mode of operation for the ECB under Trichet. However Draghi has not presided over enough changes for us to see whether he follows the same MO and his first rate cut as ECB President came as a complete surprise.
Why the ECB Rate Decision Could be a Win-Win for EUR
Given expectations from economists, the greater risk is no action from the central bank but regardless of the outcome this could be one of those unique situations where the EUR/USD could rally if the ECB cuts interest rates OR leaves them unchanged. Normally an interest rate cut is negative for a country's currency but Europe desperately needs stimulus from their central banks and a rate cut from the ECB could actually induce a rally in risk and in turn the EUR/USD. In other words, the ECB rate decision could be a win-win for the euro. If the ECB leaves rates unchanged, the EUR/USD could be squeezed higher. If they cut interest rates by 25bp, the EUR/USD will probably sell-off initially but recovery in the days that follow as investors look at the addition of stimulus as an antidote for weak growth in the Eurozone.
The following table shows how the Eurozone economy has performed since the last monetary policy meeting. As you can see, there has been a lot more weakness than strength with deterioration in labor market conditions, manufacturing and service sector activity. The commitment to austerity by European governments will only weaken economic conditions in the Eurozone, which is why the region desperately needs monetary stimulus. However, the ECB could also wait another month before cutting interest rates. The financial markets and European bond yields have stabilized enough to buy the ECB some time.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.