Why BoE is Expected to Ease and ECB is Not

Both the Bank of England and the European Central Bank will be making monetary policy announcements on Thursday. The market expects the ECB to remain on hold and BoE to increase their asset purchase program by GBP 50 billion. A quick look at the following tables explain why the BoE is expected to ease and the ECB is not. Since the last monetary policy meeting, Eurozone economic data was neutral / mixed to bullish. U.K. data on the other hand was neutral / mixed to bearish.

FOMC, ECB, RBA Meetings: What is Priced in?

The Federal Reserve, European Central Bank and the Reserve Bank of Australia have monetary policy meetings scheduled this week and some investors expect these central banks to change monetary policy. Here’s what the market is pricing in according to interest rate futures. You can compare them with the Central Bank expectations back in September. What is interesting is that the market does not expect the ECB to cut interest rates this year even though many economists predict a 50bp cut in December.

FED – Nada for 2011 and 2012

ECB – 25bp rate cut by July (sharp upgrade from Sept when rate cut expected in Dec)

BOE – Nada for 2011 and 2012 but slight shift to dovish bias

BOC – Rate Cuts now expected in 2012, down from rate hike by April

RBA – 25bp Rate cut by Dec – upgrade from 100bp by year end

RBNZ – No Major Changes, Rate Hike Expected July 2012

And here are the details:

EUR/USD: Past Reaction to Strong Vigilance Words

The big focus tomorrow is on ECB President Trichet’s press conference. The European Central Bank is not expected to raise interest rates, but Trichet IS expected to pave the for a rate hike in July. Over the past few years, the words “Strong Vigilance” have been synonymous with “interest rates will be increased next month.” Regardless of whether this has been priced in or not, it seems that euro traders almost always respond positively to the words strong vigilance.

The following charts show how the EUR/USD reacted in the days that followed central bank meetings where the words “strong vigilance were used.” Since Trichet took the role of European Central Bank President, he has used these two magic words 17 times.

On the day that these words were used, the reaction in the EUR/USD can be choppy – the currency pair ended the day in positive territory only 64% of the time, or on 11 occasions.

However from the day of the rate announcement to 48 hours later, the EUR/USD appreciated 70% of the time or on 12 occasions. The strongest pattern is seen on a 72 hour basis. History shows that when the words strong vigilance are uttered by Trichet, the EUR/USD appreciated 76% of the time. This suggests that even though the EUR/USD pulled back today, if Trichet says “strong vigilance” is needed on inflation, expect the EUR/USD to resume its rise.

ECB Rate Decision and Impact on EUR

– Rates currently at 1.00%
– 25bp rate hike completely priced in for Thurs
– 50bp priced in by June
– 100bp priced in by end of year

The most anticipated event risk this week is the ECB’s monetary policy decision on Thursday and the euro has rallied strongly ahead of the announcement. For the first time in 2 years, the ECB is expected to raise interest rates. Having brought rates to a record low of 1.00 percent, Trichet has made it clear that a 25bp rate hike is needed to avoid a further rise in inflation expectations. Recent comments from ECB officials have been very consistent and a 25bp rate hike has been completely priced into the market. In fact, traders are pricing in a 50 percent chance that interest rates will be increased by 50bp. We believe that a half point hike is extremely unlikely given how central bank officials have stressed the need to raise rates gradually. It would be smarter for the central bank to split this up into two separate moves than one large move there is little reason for the ECB to act quickly, let alone aggressively. What is more likely however is that the ECB raises rates and then signals the need for further tightening in the months to come. The strength of the euro indicates that investors expect hawkish comments from the ECB.

Should ECB President Trichet disappoint by downplaying the need for further tightening, the euro could come crashing down because the only thing holding it up is rate hike expectations. Despite continued downgrades by rating agencies and the earthquake in Japan, the ECB still believes that normalization needs to begin now. As a result, we expect the euro to remain strong going into Thursday’s announcement but the reaction to the rate decision could be less favorable. How the euro responds to the rate hike depends on what ECB President Trichet says at 8:30 NY Time. If he indicates that this is a one off rate hike, investors could end up selling euros but if he signals that they will continue to tighten in the coming months, then not only could the EUR/USD sustain its gains, but it could extend to 1.45.