All over the world central banks are dropping key interest rates in an attempt to stimulate lagging economies. Why then would the head of the European Central Bank leave interest rates unchanged despite wide spread economic turmoil among EU countries? Kathy Lien shares her thoughts on Trichet's controversial decision, along with the potential impact to currency markets, in her blog post below.
Here is a snippet of my comments about this morning’s price action on FX360.com:
There has been a lot of action in the currency market this morning, mostly centered on the British pound and Euro.
ECB President Trichet is not buckling under pressure. After leaving interest rates unchanged at 2.00 percent, he refused to make any decisive comments on where interest rates are headed in March. Trichet is still buying time to see how the economy and price pressures respond to their recent rate cuts. The Euro has held steady because Trichet said he is not pre-committing or excluding anything. The zero interest rates that Prof Roubini is calling for is out of the question especially for a central bank that remains obsessed with inflationary pressures. Trichet acknowledged that inflation will continue to fall but he expects it pick up in the second half of the year and if oil prices rebound, the acceleration of price pressures could exacerbate. Rather than being completely downbeat about growth, Trichet said that even though the risks are clearly to the downside, there are signs of stabilization. By postponing rate cuts, Trichet is putting his credibility and reputation on the line.
The ECB cannot stop cutting interest rates at this time especially as we continue to see very weak economic data. German factory orders fell 6.9 percent in the month of December, more than double the market’s forecast. Trichet who is known for his candor has already admitted that 2 percent will not be the lowest level for Eurozone interest rates and the market may be right to bet on a 50bp rate cut in March. If he doesn’t plan to cut interest rates to 1.5 percent next month, he would not comment on the market’s expectations. Although zero interest rates is off the table, we do not think that the ECB will stop at 1.50 percent. Interest rates could fall as low as 1 percent, which is why we could see more weakness in the Euro.
EUR/GBP Crushed After BoE Rate Decision
EUR/GBP collapsed following the Bank of England’s decision to cut interest rates to 1 percent. Even though the yield advantage in EUR/GBP has increased from 50bp to 100bp in the Euro’s favor, the market is less focused on interest rate differentials and more focused on recovery. The pound is trading higher because the Bank of England and the UK are being rewarded for their aggressive monetary and fiscal stimulus. The Euro on the other hand is being punished for implementing sluggish monetary policy.
This post can also be viewed on kathylien.com.