EUR/GBP: Trading the ECB rate decision

The European Central Bank electrified financial markets a year ago by launching a landmark quantitative easing program to support the Eurozone economy. And here we are one year later; the bank is still working hard to support the Eurozone economy, prop up inflation and weaken Euro (not a policy target as per ECB!).

What markets expect?/options available with the ECB

• Deposit rate cut by at least 10 basis points

• Expand asset purchase program – by EUR 10 billion to EUR 30 billion

• Speculation about introduction of tiered interest rates (as in Japan) also exists

• LTRO

• ECB may also extend the maturity of its QE program beyond March 2017.

• If it increases the size of the QE program, it may also have to add up more assets into its shopping list.

• It may also consider scrapping the ban on buying bonds with yields below deposit rate.

The bank is also likely to revise its inflation forecasts lower and blame slowdown in China and other EMs for weak growth.

What’s priced-in?

A 10 basis points cut in the deposit rate cut is already priced-in –

• Deposit rate stands at -0.30%, while the German 2-yr yield stands at 0.55%.

• This means even if we assume deposit rate is cut by 10 bps tomorrow, the 2-yr yield is still 15 basis point below the new rate i.e. 0.40%

ECB has scope to surprise through other instruments

Central banks do take a note of policy tools implemented by across the globe and how markets responded to the same. The BOJ experiment with negative rates on January 29 was not well received by the markets –

• Yen fell on Jan 29 only to recovery and gain further ground in the following week. The move also failed to prop up stock markets

• It also led to rally in gold, which indicates markets are worried about central banks diving deep into the uncharted territory and how they would manage the road back to normalcy

Consequently, ECB could do little on deposit rate front and the aggressive easing stance has to be put forward via other tools, preferably QE.

Markets do expect ECB to expand its QE program, but that may not have been priced-in, which is why EUR/USD refused to drop in the last few days and in fact attempted to break above its 200-DMA.

Stage set for ECB over delivery

• Markets expectations regarding ECB action are quite limited this time. Hence, even a slightest of aggressive action could result in a sharp fall in EUR.

• Oil is on the rise. The last week’s positioning data revealed bullish oil bets are at record highs. Thus, timing is perfect for the ECB to press the easing button as falling EUR amid rising oil could help bank achieved inflation target earlier than anticipated. (Higher oil and weaker EUR translates to a much faster rise in imported inflation).

• Fed is widely expected to come out dovish next week, hence there is a risk of a sharp rally in EUR if the ECB under delivers.

Impact on EUR/GBP

Daily Chart

• The cross is finding support around 0.7705 (23.6% fibo of 0.6981-0.7928) after having come-off its multi –month high and in process having breached the rising trend line seen on the daily chart.

• An ultra dovish ECB risks sending the EUR/GBP cross all the way down to 0.7547 (38.2% fibo of 0.6981-0.7928) in the next few days.

• On the other hand, ECB under delivery may see the cross jump above 0.7848 (50% Fibo of 0.8766-0.6931) in the next few days and move towards latest cyclical high of 0.7928.

Going by the chart alone

• A rebound from 0.7705 (23.6% fibo of 0.6981-0.7928) followed by a break above rising trend line resistance seen around 0.7790 would shift risk in favor of a rise to 0.7848

• On the other hand, a break below 0.7681 (weekly 10-MA) could see the pair drift lower to 0.7630, which if breached on the daily closing basis would mean increased odds of a drop to 0.7565 (weekly 100-MA) – 0.7547 (38.2% fibo of 0.6981-0.7928).

EUR/GBP bears need to be cautious as the cross risks sharp recovery (from post ECB easing lows), if Brexit fears make a comeback.

UK side of the story is not impressive. Brexit fears can make a comeback anytime, while the forward looking (PMI) domestic demand has been disappointing. Consequently, if the ECB under delivers, the resulting gains in the EUR/GBP cross could be massive.