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On Thursday 5th July 2012 the European Central Bank will conclude its latest meeting and will announce its policy decision at 1245 BST/ 0745ET. At 1330 BST/ 0830 ET Mario Draghi, the President of the ECB, will hold a press conference explaining the Bank's decision.

The EU summit to spark ECB action?

The market expects the ECB to cut interest rates by 25 basis points to 0.75%, according to a Bloomberg survey of analysts. If the Bank does cut rates it would mean they will be at a fresh record euro-era low. Expectations have been growing that the Bank will cut since the EU summit on the 28/29th June. At recent meetings the Bank has pressured governments to take action to bring the sovereign debt crisis under control. The decisions taken by European leaders at the summit including a banking union, greater flexibility for the EFSF/ ESM rescue funds and scrapping senior status for European authorities on bailout loans for Spain's banking sector could spur the ECB into action. In the past we have seen the ECB adjust policy after Europe's politicians have taken steps to address the crisis. For example, in December 2011 the ECB announced a long-term lending programme after Europe's politicians had agreed a fiscal compact for the Union.

There is also some expectation that the Bank could cut the deposit rate that banks' earn when they put their money in the ECB. Banks are still leaving hundreds of billions with the ECB each night, and by cutting the interest rate to 12.5 basis points, as some expect, it may detract banks from keeping their money with the central bank and instead lend it out.

Is a rate cut enough?

Growth in the currency bloc is extremely weak. The June manufacturing PMI reading remains below the crucial 50 level that points to economic expansion. Unemployment rose to its highest ever euro-era level in May to 11.1% and inflation pressures across the currency bloc are falling. Producer prices fell to their lowest level since April 2010 in May, a major factor weighing on growth in the currency bloc is austerity, and at the EU summit there were no signs that austerity programmes in bailed out countries would be slowed down or that fiscal targets would be lowered for countries like Spain. The growth pact delivered an extra EU 120bn for European Investment Bank to try and boost growth in the region, although this is a small amount in the scale of things. Thus, we believe a rate cut is more of a symbolic action from the ECB at this stage.

The market impact

A rate cut may have more of an impact on struggling peripheral economies if it helps to weaken the euro. Although German yields are lower than US yields, the spread between German and US 10-year government bond yields has been recovering in recent weeks as the sovereign debt crisis has shown signs of stabilisation, which could limit further downside for the single currency. Going forward we think that two opposing forces could weigh on EURUSD: a reduction in credit risk in Europe's periphery is euro positive, while rate cuts are traditionally euro negative. Thus we could see this cross remain in a 1.22- 1.27 range for the next couple of months. In the short-term we may see EURUSD come under pressure, and potentially re-test 1.2450 as the rate differential between Europe and the US would narrow if the ECB cuts rates. We believe the euro may under-perform against the commodity currencies like the Aussie and Canadian dollars in the coming weeks and months. Commodity currencies tend to out-perform when global central banks loosen monetary policy or boost liquidity, thus a short EURAUD position may benefit from the ECB rate cut. At the time of writing we are trading around 1.2260. We believe a move towards 1.22 then towards 1.20 is possible in the wake of a rate cut by the ECB and a pledge from it to support Europe's governments in their efforts to stabilise this crisis.

The Bank of England turns on the taps

Also on Thursday 5th July at 1200 BST/ 0700 ET we expect the Bank of England to boost quantitative easing by GBP50bn to GBP375bn after the economy slipped into a double dip recession at the start of this year and economic data has remained weak in the second quarter.

One of the reasons we believe the BOE may boost QE at this meeting is that the Governor Mervyn King announced that the BOE was considering taking further policy action at the annual Mansion House dinner in the City in June, thus if the Bank does not follow through with more QE at its meeting this month it risks losing credibility with the markets.

QE: a symbolic move

Will more QE help the UK's economy? There is a lot of evidence to suggest that rounds of QE has diminishing marginal benefits, especially as interest rates are already low at 0.5% and long-term interest rates are close to record lows at 1.7%. However, we believe the Bank may choose to act now as the UK economy remains at risk form the Eurozone sovereign debt crisis and more gilt purchases is the easiest policy change to vote on at the moment. More QE could go hand-in-hand with the new BOE/ Government initiative to get banks' lending called Funding for Lending. This would make it easier for banks to get access to funds from the BOE if they boost their lending to the private sector. However, there are two problems with this: 1, banks may not have stressed funding conditions and may not need to tap the BOE, and 2, economic confidence in the UK is extremely low, which could dampen demand for credit. Thus, we believe if the BOE does announce more QE at its meeting on Thursday, it won't signal any further action and instead it may say that it will monitor the impact of QE and the Funding-for-Lending programme until the next Inflation Report is released in November.

The impact on the pound

In the past the pound has remained extremely resilient to more QE. Thus we think that further downside in GBPUSD is limited. This cross is likely to move with overall risk appetite, and in the near-term may remain range-bound between 1.5500 - 1.5750. EURGBP is also likely to remain fairly range-bound after reaching multi-year lows recently. We prefer selling the pound versus commodity currencies due to the limited downside we foresee for the pound against the major currencies like the dollar and the euro, and look for a gradual decline in sterling against the Australian dollar in the medium-term. Support lies at 1.50 in this cross and then 1.4750 - the record low from February this year.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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