The European Central Bank will announce its latest decision on interest rates. This is one of the most anticipated meetings in recent months as the market is pricing in a rate cut from the ECB this month, which would be the first cut since April. Also worth watching is ECB President Draghi, who is scheduled to give his regular press conference at 1330 GMT/ 0830 ET.
Rate cut expectations have surged in the last week after a sharp drop in Eurozone inflation for September. The annual rate of headline CPI dropped to 0.7% from 1.1% in August, the lowest level since 2009. This has sparked fears of deflation, particularly in the weaker peripheral states. Since the ECB's mandate is to maintain stable prices, the question is whether inflation is a big enough cause of concern to trigger more stimulative action from the ECB, or if the Bank will take a more pragmatic approach to falling prices, as it has in the past.
The problem for the ECB is that prices are falling at a faster rate in the periphery compared with the core; for example, German inflation is at 1.2% compared to Spain, which is already experiencing deflation. The prospect of deflation in the peripheral economies is a double-edged sword: on the one hand it is necessary to make the weaker economies more competitive, yet on the other hand it increases their already hefty debt loads (inflation can erode the value of your debt).
The arguments for a small rate cut to 0.25% from 0.5% include:
A rate cut is a relatively easy monetary response to the recent weakening in the Eurozone economy and the sharp drop in inflation, it could also dampen the EURUSD, which is being blamed for causing inflation and growth to slow.
The ECB does have room for a rate cut and it would bring ECB rates in line with rates in the UK and the US.
The arguments against a rate cut:
One 25 bp cut is unlikely to impact the Eurozone economy in a material way.
EURUSD has fallen sharply in recent sessions from 1.38 to below 1.35, more than 2.5%. Thus, the market may have done the ECB's job for it since a weaker EUR could ease deflation pressures down the line.
The ECB has been remarkably tolerant of low inflation in recent months and there are still signs of growth in the currency bloc, which could make the ECB hesitant to cut rates at this juncture. For example, the composite PMI remained in expansion territory in October.
The ECB may choose to cut rates in Dec rather than Nov when the Bank will have the latest staff inflation and growth projections.
Regardless of whether the ECB cuts rates at this meeting, we still expect President Draghi to reference the drop in inflation. We will be watching to see whether he thinks this has impacted long-term inflation expectations in the currency bloc, if it has then the ECB may be forced to act in order to fulfil its mandate. In the past Draghi has surprised the market with his rhetoric, thus it is worth watching to see if the problems of the periphery, or the predicament of the core, is foremost in the ECB's minds.
We will also be watching out for further clarification on the ECB's forward guidance. Will the Bank try to anchor forward guidance to an economic threshold or a specific period of time in the future? This could limit the upside for European rates even if the US goes ahead and starts to taper in the next couple of months, which could put upward pressure on US Treasury yields.
Market reaction?
Mario Draghi has surprised the markets before with his decisions and rhetoric, so rather than try to second-guess the ECB, below are a few scenarios for potential outcomes and the impact on EURUSD.
ECB cuts rates and sounds dovish, and anchors forward guidance to a threshold: this would be the most dovish outcome in our view, and could trigger a fresh bout of selling in EURUSD. Key support lies at 1.3445 - the top of the daily cloud. Below here is a bearish development that opens the way to 1.3355 - the daily cloud base.
ECB does not cut rates but points to a rate cut in December: this is also bearish for EUR in our view and after a knee-jerk push higher after the no-change announcement at 1245 GMT; we could see any strength get faded by the market once Draghi starts speaking in dovish tones. 1.3355 - daily cloud base - is also a support level to watch.
ECB does not cut rates and does not sound worried about the decline in inflation: this would be the most bullish outcome for EURUSD In our view and could trigger a sharp reversal in the single currency as the market is forced to ditch its dovish ECB bias. We may see back to 1.3560 - Fib resistance, and then 1.3630 - a high from early October. We could also see EURGBP stage a mini recovery and EURJPY come under some upward pressure, as the BOJ would look more dovish than the ECB in this scenario.
Rate cut expectations have surged in the last week after a sharp drop in Eurozone inflation for September. The annual rate of headline CPI dropped to 0.7% from 1.1% in August, the lowest level since 2009. This has sparked fears of deflation, particularly in the weaker peripheral states. Since the ECB's mandate is to maintain stable prices, the question is whether inflation is a big enough cause of concern to trigger more stimulative action from the ECB, or if the Bank will take a more pragmatic approach to falling prices, as it has in the past.
The problem for the ECB is that prices are falling at a faster rate in the periphery compared with the core; for example, German inflation is at 1.2% compared to Spain, which is already experiencing deflation. The prospect of deflation in the peripheral economies is a double-edged sword: on the one hand it is necessary to make the weaker economies more competitive, yet on the other hand it increases their already hefty debt loads (inflation can erode the value of your debt).
The arguments for a small rate cut to 0.25% from 0.5% include:
A rate cut is a relatively easy monetary response to the recent weakening in the Eurozone economy and the sharp drop in inflation, it could also dampen the EURUSD, which is being blamed for causing inflation and growth to slow.
The ECB does have room for a rate cut and it would bring ECB rates in line with rates in the UK and the US.
The arguments against a rate cut:
One 25 bp cut is unlikely to impact the Eurozone economy in a material way.
EURUSD has fallen sharply in recent sessions from 1.38 to below 1.35, more than 2.5%. Thus, the market may have done the ECB's job for it since a weaker EUR could ease deflation pressures down the line.
The ECB has been remarkably tolerant of low inflation in recent months and there are still signs of growth in the currency bloc, which could make the ECB hesitant to cut rates at this juncture. For example, the composite PMI remained in expansion territory in October.
The ECB may choose to cut rates in Dec rather than Nov when the Bank will have the latest staff inflation and growth projections.
Regardless of whether the ECB cuts rates at this meeting, we still expect President Draghi to reference the drop in inflation. We will be watching to see whether he thinks this has impacted long-term inflation expectations in the currency bloc, if it has then the ECB may be forced to act in order to fulfil its mandate. In the past Draghi has surprised the market with his rhetoric, thus it is worth watching to see if the problems of the periphery, or the predicament of the core, is foremost in the ECB's minds.
We will also be watching out for further clarification on the ECB's forward guidance. Will the Bank try to anchor forward guidance to an economic threshold or a specific period of time in the future? This could limit the upside for European rates even if the US goes ahead and starts to taper in the next couple of months, which could put upward pressure on US Treasury yields.
Market reaction?
Mario Draghi has surprised the markets before with his decisions and rhetoric, so rather than try to second-guess the ECB, below are a few scenarios for potential outcomes and the impact on EURUSD.
ECB cuts rates and sounds dovish, and anchors forward guidance to a threshold: this would be the most dovish outcome in our view, and could trigger a fresh bout of selling in EURUSD. Key support lies at 1.3445 - the top of the daily cloud. Below here is a bearish development that opens the way to 1.3355 - the daily cloud base.
ECB does not cut rates but points to a rate cut in December: this is also bearish for EUR in our view and after a knee-jerk push higher after the no-change announcement at 1245 GMT; we could see any strength get faded by the market once Draghi starts speaking in dovish tones. 1.3355 - daily cloud base - is also a support level to watch.
ECB does not cut rates and does not sound worried about the decline in inflation: this would be the most bullish outcome for EURUSD In our view and could trigger a sharp reversal in the single currency as the market is forced to ditch its dovish ECB bias. We may see back to 1.3560 - Fib resistance, and then 1.3630 - a high from early October. We could also see EURGBP stage a mini recovery and EURJPY come under some upward pressure, as the BOJ would look more dovish than the ECB in this scenario.
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