The first meeting of the European Central Bank (ECB) for 2012 is scheduled for Thursday 12 January at 12:45 GMT whereby discussions will be held about monetary policy and whether to change EU interest rates.

Risk sentiment in the market remains fragile - eurozone debt crisis intensifies

The economic situation in the eurozone appears to be worsening. Greece faces a race against time to act in order to avoid a default in March. The highly indebted country needs to secure a second bailout package from the European Union and the International Monetary Fund and investors are closely watching the Private Sector Involvement (PSI) plan, hoping the terms and structural reforms will be finalised before the EU summit on 30 January. In Italy, while Mario Monti’s reforms focus on growth, the market continues to punish the economy as Italian yields continue to be near 7%, a level considered to be unsustainable. To make matters worse, rating agencies also warn that Italy’s and France’s credit rating are still at risk after Hungary was downgraded to junk status. The euro has fallen to a 16-month low against the greenback and remains under pressure across the board.

Recent economic data surprised the markets after showing the pace of economic contraction in the eurozone slowing. The purchasing managers index, trade balance and gross domestic product (GDP) showed encouraging figures. German Chancellor Angela Merkel and French President Nicolas Sarkozy said, in a meeting this week, that priority is to boost growth in the eurozone and act to resolve the debt crisis.

Euro as a funding currency

Some economists are now starting to believe the single currency is replacing the US dollar as a funding currency. Investors may find that the euro is an attractive currency to use for carry trades, where investors borrow euro to invest in high yielding currencies. Analysts expect the euro to weaken further this year making it more attractive to investors as a funding currency. They also expect that the ECB will cut interest rates further this year while no more quantitative easing is expected from the US as the US economy appears to be recovering.

The scenarios

After cutting the interest rates by 25 basis points in both November and December, investors expect Mario Draghi to be more cautious on Thursday. No change in the interest rates or further liquidity is expected after the central bank injected 489 billion euro of ultra-cheap loans into the market last month. Such a scenario may be already priced in market expectations and a muted reaction is expected. In the scenario where a 25 basis points interest rate cut occurs this may surprise investors and put increased pressure on the euro causing it to seek new lows.

Investors’ real focus will be on the press conference by the ECB President Mario Draghi at 13:30 GMT, where signals for the future monetary policy will be closely watched. In a scenario where Draghi emphasizes on the heightened eurozone debt contagion risk and adopts a dovish stance, expectations for additional easing and a possible zero interest rate policy may rise. This may trigger a sell-off in the euro. Whatever the outcome, Thursday will provide an insight into Europe’s future economic picture.