Market View: ECB disappointment could see EUR/USD move higher

By Justin Pugsley, Markets Analyst MahiFX

Eurozone unemployment levels are hitting new records whilst inflation is softening and with much of the continent mired in an economic depression hopes are running high that the European Central Bank will cut interest rates. Even if it did it would only be a symbolic gesture, but one that forex markets would pay close attention to.

A 25 basis point rate cut on its key refinancing rate to 0.5% from the ECB would have a minimal impact on the real economy, though it would make headlines given it would the first reduction since July 2011. More importantly for the forex markets it might signal that a more aggressive monetary stance is on the cards.

What will probably matter more than whether rates are cut or not is what ECB President Mario Draghi says at the press conference on Thursday morning in Europe. He may well seek to address market chatter about more aggressive monetary policy, but may not say what many market participants are clearly hoping for. So it could be rate cut combined with words to curb any enthusiasm on more imaginative forms of monetary policy.

Crucially the Consumer Price Inflation index in the Eurozone was 1.2% in April, the lowest in over two years and is well below the ECB’s 2% target. So there seems little reason to hold back on a rate cut or to even to contemplate more aggressive monetary policy, at least in the opinions of many market participants.

Kill joy Germany

None of this is a dead cert. Germany for one has been critical of the ECB with even calls to cancel it’s very successful Outright Monetary Transactions programme, which has been vital for driving down borrowing costs for peripheral Eurozone countries without ever being deployed.

Exploring more creative forms of monetary policy, such as quantitative easing, are not likely to be contemplated at this stage not least because it might be too difficult for Germany to swallow politically. Another issue is that the ECB has very conservative views on fiscal policy and there is a steady shift in Europe towards easing up on austerity programmes. The ECB therefore may take the view that there is less need to rely so heavily on monetary policy.

The real problem in the Eurozone is the lack of demand and the fact that ‘cheap money’ is in many cases simply not reaching households or small businesses. As the ECB has often said it is limited in what it can do to stimulate an economic recovery.

So given the EUR has been steady recently, a rate cut might be the best the forex markets can hope for. The ECB only tends to engage in extreme measures when under extreme duress, such as when the EUR is collapsing and peripheral government bond yields are soaring. That’s not happening right now.

So market expectations might be set for disappointment and that could see EUR/USD make gains on the upside and it seems some traders are already contemplating such as outcome.

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