With
the approaching of the ECB meeting on Thursday it seems the markets
are getting more nervous and volatile. EUR lost more than a percent
against USD on Monday and regained that percent back in Tuesday. US
equities followed suit although their movements were far bigger and
the changes were about 3% in both directions. The "fear index"
VIX moved about 10% up and down for the first two days of the week.
The
US equity markets finished strongly upward on Tuesday as FED's
chairman Mr. Bernanke assured the markets "he’ll push forward
with further expansion of monetary stimulus if needed ". After
the strong selling during the last weeks and rebounding from the new
low for the last two months made on Tuesday, the market seems hungry
for good news. Mr. Bernanke's speech fitted well into such market
expectations.
On
the other side of the ocean Europe is still struggling with its
sovereign debt problems. The Moody's Investor Service cut Italy's
credit rating to A2 from Aa2 which at first made European equity
markets to stay behind the increase of the US market from Tuesday.
Later during the day the EU stocks advanced. Such an increase amidst
credit rating downgrade (although possibly expected), an unexpected
drop in EMU Retail Sales (YoY) of -1% and a decrease in Purchasing
Manager Index Services in EMU could speaks of a strongly oversold
sentiment. The same sentiment seems to be present in the US equity
markets also.
So
if everyone is focused on the ECB decision on the interest rate on
Thursday, let's elaborate a bit on the possible outcomes.
Chart
1. Inflation in euro area, annual, non-seasonally adjusted; Source:
ECB
The
market consensus is that the ECB would leave its rate untouched at
1.5%. Any deviation from that consensus could sparkle market
movements in both directions. Even if the ECB does not change the
rate, the language it would use in the press release could signal the
bank's further intentions.
In
general ECB is strongly concerned with price stability. The last data
on inflation in EMU showed an increase to 3% on annual basis after
previously decreased a bit. Thus the market consensus that ECB would
leave the rate unchanged seems reasonable enough as any further
increase in the money supply by lowering the rate has the potential
to increase the inflation pressure.
On
the other hand data from October 5, 2011 show the growth in euro area
slowed significantly to 1.6% (YoY) from the previous 2.5%. The
combination of a high inflation and a slow growth does not seem to be
in favor of any further increase in the ECB interest rate in the
short-term. Such a combination however, does neither support a strong
decrease in the rate which the currency markets seem to be hoping for
as that would boost inflation. So basically that puts the two extreme
options – an increase in the rate and a strong decrease out of the
table for now.
We
are then left with those two – rates unchanged as is the market
consensus and a small decrease which would be a surprise given the
consensus.
If
the interest rate is left unchanged that would not have any
significant direct effect on the markets as this outcome seems
already priced in. The markets could continue to be moved mostly by
oversold moods and short rallies. Not lifting the rate given the
present weakness of the euro combined with the sovereign debt
problems in EU however, could signal the ECB is not so strongly on
the euro defensive position at the moment. That could increase the
short-term confidence in the EU common currency or at least not hurt
it further. All that however does not seem so strong to present a
long-lasting and deeper change in the market sentiment if we account
for the sovereign debt problems as well.
The
second option which seems possible given the slowing growth, is a
decrease of .25 basis points to 1.25%. Such an decrease would not
hurt so much the interest rates differential between USD and EUR as
to strongly send the Euro further down. Such a strongly weaker euro
scenario does not seem a desirable outcome for the EU officials
either.
A
small decrease in the rate would be a surprise given the consensus
and could give equity markets confidence the ECB is concerned with
growth in EU at least as much as it is with price stability. That
could more possibly result in EU markets increase than in US but in
general both markets follow suit. The current negative sentiment
resulted in a bit oversold market condition on both sides of the
ocean and lead to a series of bullish divergences in EU stock markets
on a short-term scale. In this light such a decision could lift up
the world equity markets for a while as it would mark a possible
shift in risk taking. In a longer perspective however, the
commodities prices should be watched as they are able to present a
big pressure on a macro level and limit growth while increasing
inflation.
