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Research Note: Nov. 6 BOE and ECB Rate Decisions
Brian Dolan, Chief Currency Strategist
Jacob Oubina, Currency Strategist
Summary Outlook: (November 5, 2008) Financial markets are still recuperating after October's meltdown and risk appetites are making a tentative recovery. We think tomorrow's interest rate decisions are best viewed against this 'risk appetite' backdrop instead of the standard interest rate relationship normally applied to currencies (rates down/currency down and vice versa). In this light, the larger the rate cuts, the better for each currency, as markets seem more likely to respond favorably to lower interest rates as an additional boost to weak economic outlooks. Conversely, smaller-than-expected rate cuts (see below) would most likely be greeted with disappointment and see stock markets react negatively.
Specifically in FX, we expect to see an initial drop in EUR/USD and GBP/USD as rate cuts are announced, but for such losses to be quickly reversed. Should the BOE cut more than the expected 50 bps, the GBP drop may be sharper, but eventually it should also be reversed. We would look at comments from the BOE or ECB signaling willingness to lower rates further as another boost to overall market confidence, which should be seen in positive stock market reactions. With this view, our trading strategy focuses on buying the FX "risky asset," which is the JPY-crosses, namely EUR/JPY and GBP/JPY.
Trading Strategy: Due to heightened market volatility, specific price level recommendations are likely to be superseded by market movements between the time of this writing and the rate announcements. Instead, we would suggest using price increments from where the pairs are trading at the time of the announcement as the gauge of where to step in.
EUR/JPY: we look to buy dips between 50-100 pips from pre-decision levels; stop at -200 pips (for a risk of between -100/150 pips from long entry).
GBP/JPY: we look to buy dips between 100-150 pips from pre-decision levels (150-200 pips if the cut is more than 50 bps); stop at -250 pips (for a risk of -100/150 pips from long entry).
Decision Analysis:
The Bank of England is set to meet on Thursday and announce rates at 0700ET/1200GMT. The consensus is for a -50 bps cut in rates to 4.00% but the outlook is contentious. Several economists predict that the BOE will be more aggressive and cut rates -75 bps while others are looking for an even sharper -100 bps reduction. There is no question that economic activity has deteriorated, with some BOE members going as far as acknowledging that the UK is in recession well into 2009. Inflation has become a non issue with expectations that it will continue to fall over the next year now commonplace. Thus the statement out of the BOE should not be a surprise to markets. The divergent estimates for the level of rate cuts, however, suggest that the price action in GBP around this event could be quite volatile.
The European Central Bank is scheduled to meet on Thursday and announce rates at 0745ET/1245GMT. The consensus is unanimous in expecting a -50 bps reduction to 3.25% and the futures market is priced for a cut of that magnitude as well. The rate cut is likely to be a non-event unless the ECB surprises markets with a less than expected cut of say -25 bps. The subsequent press conference from ECB President Trichet at 1330GMT will garner most of the attention. Trichet is expected to acknowledge the continued deterioration in EU economic fundamentals while likely giving some lip service to the risks of inflation.
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.
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