Tomorrow's ECB rate announcement due 12:00GMT is shaping up to be one of the key events in the central bank's ten year history. With Euro-zone economy facing one of the worst economic slowdowns in decades Mr. Trichet and the governing council are under enormous pressure to abandon his Bundesbanke-like rhetoric and begin to ease aggressively.
The consensus is for 50bp rate cut and although we do not think that Mr. Trichet will exceed analyst expectations, we do believe he will signal a much more dovish stance going forward. Over the years, one of ECB's principal concerns in managing the Eurozone monetary policy has been price stability.
To that end ECB has always erred on the side of caution and as result has maintained its rates far higher than its G-4 counterparts. Presently EZ rates are more than 200bp higher than those of US and Japan and 100bp higher than the rates in UK. However, with the latest German whole sale price data printing at -3.0% (far below the consensus estimates of -1.7%) any lingering doubt s about inflationary pressures in the region have long been extinguished and the market now expects the ECB to come in line with the rest of the G-4 central banks.
Ahead of the ECB announcement the currency market will get a glimpse of EZ CPI data for December and should that report surprise to the downside, it will open the way for ECB to act more aggressively over the next several months.
The ECB is a notoriously conservative institution and Mr. Trichet does not like to surprise the market. Therefore tomorrow's Q&A session will be critical to understanding the EZ monetary policy going forward. Although Mr. Trichet is sure to reaffirm his statements about not pre-committing, if he acknowledges the gravity of the situation in EZ economy, the market will take his words as a signal of another 50bp cut within a month.
With EUR/USD having dropped substantially ahead of the rate announcement, there is serious possibility that that the unit could actually rally in the aftermath of the news release in a typical buy the rumor sell the news dynamic. The rally could also be exacerbated to the upside, if Mr. Trichet remains stubbornly hawkish despite the dour economic reality on the ground. However, with the market having reached a consensus that EZ rates must be lowered sooner rather than later, the sentiment on the single currency remains decidedly bearish and any rally will likely prove to be an opportunity to sell as the euro gears up for a test of the 1.3000 handle in the near future.