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A big day for Draghi:
On Thursday 2nd August 2012 the ECB will announce its latest policy decision at 1245BST/ 0745ET. At 1330 BST/ 0830 ET, ECB President Mario Draghi will hold a press conference explaining the Bank's decision.
The markets will be particularly interested in hearing from Mario Draghi as he recently boosted expectations that the Bank would take action to reduce the borrowing costs for Spain and Italy at this month's meeting. Without spelling out the steps the Bank would take, Draghi said at a conference in London last week that the rise in sovereign borrowing costs for Spain and Italy had impaired the effectiveness of its policy tools and it would do all it could, within its mandate, to support the euro.
There are three interesting elements to watch out for at this meeting: 1, to see if Draghi can deliver after last week's speech. If he fails to offer support for Spain and Italy than his personal credibility could go out the window. 2, what sort of support the Bank will offer. It needs to ensure its policy tools are effective but it can't step outside of its mandate and directly re-finance governments within the currency bloc. 3, Germany has been opposed to ECB sovereign bond purchases and this week the head of the Bundesbank Jens Weidmann said that the ECB must not overstep its mandate, that governments overstate the ECB's "possibilities" and that the Bundesbank has a "greater say" at the ECB than some others. His comments seem to stand in opposition to the message that Draghi sent last week. We will find out who comes out on top at tomorrow's press conference, and the outcome could be pivotal to the resolution of the debt crisis.
The ultimate outcome for markets in our view would be for the ECB to become the lender of last resort for the currency bloc and announce that it will buy up unlimited amounts of government debt until Spain and Italy's borrowing costs come down to a more sustainable level of approx. 4%. However, the actual outcome is likely to be more moderate than this. We think the Bank will announce it is re-starting its SMP programme; however it is likely to put a strict limit on how much it will buy. It may also impose conditions on these bond purchases so that Spain and Italy don't delay reform programmes. Thus, the Bank may announce that it will buy debt alongside the EFSF rescue fund. This does two things: 1, the rescue fund can impose conditions on governments to ensure they stick to their reform programmes. 2, it means the ECB does not have to grant the rescue funds a banking licence which is extremely controversial and disliked by Germany.
We agree with consensus and expect the Bank to keep rates on hold at 0.75%, but there is also a chance that the Bank could cut the deposit rate (the rate it pays banks for leaving its money with the ECB) to negative to try and boost lending to the wider economies. This could be justified because growth is so weak and there are signs that deflation pressures are building.
There are a few potential outcomes for the euro from this meeting: 1, if the ECB announces a big bazooka, as mentioned above then the euro is likely to surge as credit risk declines sharply in Spain and Italy, which is euro positive. If it can clear 1.2340 then we could see back towards 1.25 in the short term. However, if the Bank announces a more muted SMP programme then this may disappoint the markets and we could see a sell-off in risk as investors question if this is enough to save Spain and Italy. The recent rally in EURUSD may have cleared the way for a clean break lower in the cross towards 1.20. Without Spain and Italy safely away from the sovereign debt fray then EURUSD is going to remain at risk from breaking below this key level. Supports lie at 1.2170 then 1.2040 (the low from last week), and we would expect a meander lower in the single currency if Draghi turns out to be more talk than action.
The Bank of England to remain on hold:
At 1200BST on Thursday 2nd August the Bank of England announces its policy decision. We agree with consensus and expect the BOE to keep interest rates on hold at 0.5% and asset purchases steady at GBP 375 billion after boosting the size of asset purchases at last month's meeting. Although growth contracted by 0.7% in Q2, it is expected to bounce back in Q3, which could stay the Bank's hand at this meeting while it waits to see how growth signals pan out at the start of a new quarter.
While we expect the BOE to boost asset purchases later this year, we think it may wait until later this year as the growth outlook remains cloudy. The chief driver of the pound is likely to remain overall market risk and events in Europe. Thus, if the ECB surprises the markets and delivers a huge programme of support for struggling members then GBPUSD could push back above 1.57 in the short term. However, we see support for the pound starting to falter, as the growth outlook weakens and the prospect of more BOE action keeps a lid on sterling gains. EURGBP is also approaching a key level at 0.7895. Above here opens the way to a re-test of 0.8000, especially if the ECB decision is received warmly by the markets.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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