Recent price action in the euro has been determined by and driven by headlines by comments from politicians and finance ministers. Tomorrow, we will get to see what the central bank policymakers response is to the deteriorating situation in the euro zone sovereign debt crisis. Economic data is showing slowdown in the euro zone, and a significant slowdown in the number one economy - Germany. This week we have seen the final readings for manufacturing and services PMI's showing activity in both sectors contracting. Along with the troubles that European banks are having finding financing a strong ECB response is warranted. Let's see how far the ECB will go when it meets tomorrow in what will be Trichet's final meeting as the head of the ECB.

MAIN OPTIONS:

1) OFFER 12-MONTH LOANS - The action that seems most certain to be taken by the ECB will be to introduce a 12-month liquidity providing auction, that is offering 12-month loans to European banks at the ECB's low rates. We have already seen the ECB offer six-month and shorter loans, as well as providing three-month dollar funding through the end of the year in an attempt to alleviate those bank financing concerns. This sets up as the status quo policy action that the ECB will take and is likely already priced into the market.

2) RESTART COVERED BONDS PURCHASE PROGRAM - Another option available for the ECB would be to restart its program of buying covered bonds. Covered bonds are those assets backed by mortgages or public-sector loans, and makes up a €2.5 trillion market. It underpins much of Europe's real estate lending. The ECB bought around €60 billion worth of covered bonds in their response following the credit crunch of 2008-2009 with that program ending in June of last year. The purpose of this action would be to free up banks' balance sheets and encourage lending by euro zone area banks. However, what it's most likely to do is shore up the balance sheets, as banks are reluctant to lend in this environment of uncertainty, especially as politicians are re-opening the possibility of forcing larger write-downs on Greece debt, which could be used as a template that could be used for other troubled periphery sovereign debt. This step would be a positive and show that the ECB is trying to use further non-standard measures to help deal with the crisis.

3) LOWERING INTEREST RATES - The third option available for the ECB would be a standard measure which would be to lower the interest rate. The ECB hiked interest rates twice this year, to 1.5% from 1%, amid a period of higher inflation and a backdrop of strong growth in the first quarter.

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However we now see that GDP in the Euro-zone grew at a tepid 0.2% rate in the second quarter and growth is expected to be slow in the second half of the year as well, if not tip back into negative growth.

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The events of the last two months caused market participants to pencil in a 50 basis point cut from the ECB in this week's meeting, which would undo the rate hikes from earlier this year. However, those expectations have now been pulled back and the ECB is expected to hold rates steady, though there is an outside chance that they lower them by 25 basis points. Most likely interest-rate cuts will be discussed by the European Governing Council, but any action may be saved till later in the year.

The picture for lowering interest rates got more complicated recently as the preliminary reading for September Euro-zone inflation jumped to an annual rate of 3% from 2.5%, knocking back the conventional wisdom that inflation in the euro zone had peaked at 2.8% back in April.

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While the ECB may not cut interest rates tomorrow, if they soften their tone in regards to inflation expectations amid expectations of weaker growth that could serve to signal to the market that interest-rate cuts will be forthcoming if the data continues to deteriorate and if inflation falls back down from its September jump.

4) ECB's HELP IN BOOSTING EFSF - There are also calls for the ECB to help stop the spread of contagion in the euro zone by working together with the Euro-zone bailout facility - the European Financial Stability Facility (EFSF) - by helping it to broaden its firepower. One way would be for the EFSF to be able to become a bank and borrow from the ECB like other banks, which would significantly increase its lending capacity. Trichet in testimony this week before the European Parliament is adamantly opposed to this idea, and in general this idea runs afoul of the treaties set up for the euro zone which prohibits monetary financing - the central bank funding of governments.

For more on the various proposals to boost the EFSF see this article - 4 Ways to Leverage up the EFSF.

ANTICIPATING MARKET REACTION

There are a couple of factors that can impact the euro as a result of the ECB's decision. For starters if the ECB decides to take options one and two that can show that it is responding to recent events with further not standard measures. That can help spark a relief rally if the market is convinced that these steps would help alleviate the pressure on the Euro-zone banks.

If the ECB decides, on top of offering 12-month loans and re-opening its covered bond buying program - to also lower interest rates that too presents the possibility of a relief rally. However, from a standard fundamental perspective it means looser monetary policy and that pressures the euro. Therefore, we should see which way market participants respond in that scenario. Also now that the conventional wisdom is the expectation that the ECB will not cut interest rates tomorrow, a move there would be a surprise and have a significant market impact.

The ECB is also likely to continue to insist that the sovereign debt problem remains a problem for governments to solve and that the ECB has already taken upon itself the responsibility of buying periphery bonds in the secondary market - including that of Italy and Spain. It does not want this job, and the risk to its balance sheet from those operation, and would rather that the EFSF or other mechanisms are in place to do it. While the ECB will continue to provide liquidity to the financial system, it also will squarely point the responsibility on governments in regards to how they raise the firepower for further support measures.

For a technical analysis look at the EUR/USD see today's Technical Update: EUR/USD Forecast: Recovery Slowing and Forming a Diagonal Triangle Under 1.3380

Nick Nasad
Chief Market Analyst
FXTimes