On Thursday at 7:45 EDT, the European Central Bank is widely expected to raise interest rates by 25 basis points to a nearly 7-year high of 4.25 percent. This would be the first change in monetary policy since last summer, and could mark a pivotal point for EUR/USD. However, the change in rates is not necessarily the most important thing to watch, as ECB President Trichet’s commentary will continue to be the prime market-mover for the euro.
Why the European Central Bank Will Raise Rates This Week
There is little doubt in the markets that the European Central Bank will raise rates on Thursday, as ECB President Jean-Claude Trichet remains the most hawkish central banker around. Mr. Trichet sparked expectations of a rate increase following the ECB’s June meeting, as he said during his monthly press conference not only that some policy makers had actually wanted to tighten monetary policy in at that meeting, but that the ECB would “not exclude the possibility of increasing rates by a small amount.” Though Mr. Trichet said that is was “not certain”, he did say that it was “possible,” which was more than enough to lead traders to expect at least a 25 basis point increase in July.
Since the ECB’s primary mandate is to maintain price stability, Mr. Trichet has all the reason in the world to consider increasing interest rates. On Monday, Eurostat reported Euro-zone CPI estimates rocketed to a fresh 16-year high of 4.0 percent in June, up from a confirmed rate of 3.7 percent in May. This is substantially higher than the ECB’s 2.0 percent inflation target, and with CPI rising faster by the month, Mr. Trichet and other ECB Governing Council members are understandably concerned. However, European government officials are concerned for a different reason: they face political repercussions if their respective economies experience sharp slowdowns. On Monday, French President Nicolas Sarkozy said, “The ECB, whose independence should be preserved, should ask itself some questions about economic growth in Europe and not just inflation. Inflation today is due to the boom in (prices of) raw materials. You can't tell me that in order to fight against inflation you have to raise interest rates. You can double, triple interest rates and that will not bring a decrease in the price of a barrel of Brent.”
To a certain degree, President Sarkozy is correct. Much of the world is currently experiencing similar problems with surging consumer prices, and it is due primarily to increasing commodities like oil and food which interest rate increases will have little impact on. However, the ECB is more concerned about “broad-based second-round effects on wages,” as increasing inflation expectations by the public may lead workers to demand higher pay. The fear is that once this sort of mentality starts to set in, companies will anticipate rising wage demands and raise their own selling costs, which will filter into even higher CPI, and so on.
How Will This Decision Impact the Markets?
Clearly, the odds are in favor of at least a 25 basis point rate increase, if not a 50 basis point hike. However, traders will need to watch out for the other big show at 8:30 EDT, when Mr. Trichet will give his monthly press conference, as this tends to be the most market-moving part of the ECB’s rate decision. Here’s a summary of what to look for, and how it may impact EUR/USD:
Scenario 1: +25bps to 4.25%, Trichet Suggest It’s A One-And-Done Deal - While the EUR/USD is likely to jump on the 7:45 EDT announcement of a 25 basis point rate hike to 4.25 percent, any sort of rally will immediately reverse if Mr. Trichet suggests in his post-meeting press conference at 8:30 EDT that the bank has no intention of increasing rates further. This is the most probable scenario, and traders should watch for comments that indicate that downside risks to growth may help to offset upside inflation risks, or notes that “the current monetary policy stance will contribute to achieving our objective” of price stability.
Scenario 2: +25bps to 4.25%, Trichet Signals Additional Hikes – As we mentioned, a 25 basis point rate increase at 7:45 EDT is very likely to spark a EUR/USD rally. However, if Mr. Trichet remains hawkish at 8:30 EDT, EUR/USD may extend even higher in following days as traders rush to price in additional rate increases this year. Comments to watch for include statements that the ECB remains “in a state of heightened alertness”, “the economic fundamentals of the euro area are sound” and notations that risks to price stability have increased further.
Scenario 3: +50bps to 4.50%, Trichet Implies That Is It – In the near-term, a 50 basis point rate increase to 4.50 percent at 7:45 EDT would be the most bullish scenario for EUR/USD, as this sort of move would be entirely unexpected. However, if Mr. Trichet were to follow this up at 8:30 EDT with the sort of commentary noted in Scenario 1 (see above), the EUR/USD would experience heavy volatility and possibly a sharp reversal. Furthermore, the news would be very bearish for European stock markets, which could subsequently lead the Japanese yen crosses lower, led by EUR/JPY, as the Euro-zone’s economies and businesses would experience a significant tightening in credit conditions.
The rally through 1.5843 eliminates the triangle count and makes the advance from 1.5303 an impulse (5 waves) with the 5th wave unfolding now. There are specific relationships among waves that often hold. For example, wave 5 tends to sport equality with wave 1. Another relationship is that wave 5 tends to travel 61.8% of waves 1 through 3. In this case, wave 5 would equal wave 1 at 1.6070 and wave 5 would equal 61.8% of waves 1 through 3 at 1.6052. This is an estimate for the end of wave 5 (which is from 1.5722). Keep in mind though that the push through 1.5843 satisfies minimum expectations for the end of wave 5. Following completion of wave 5, the EURUSD should retrace back to the 1.57 area in wave 2 of the next larger degree (labeled (2)). In summary, expect an extension of the move from 1.5722 (as long as 1.5722 holds). Ideally 1.5777 holds and potential support is 1.5800/30 (Fibonacci).
The most likely scenario for Thursday – a 25bp hike to 4.25 percent and indications that rates will not be increased further – plays out well with Jamie’s Elliott Wave analysis. Nevertheless, traders should keep an eye out for any surprises by the European Central Bank, as the news is sure to spark volatility in the euro across the majors.
Written Terri Belkas and Jamie Saettele, Analysts for DailyFX.com
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