The ECB is expected to raise rates by 25 basis points on Thursday. The central bank officials have telegraphed the move so there should not be a surprise on the announcement. What would be a surprise is if the central bank chooses to increase rates by 50 basis points instead of 25 basis points, or if ECB’s Trichet is overly hawkish in his comments at his customary press conference.
The increase is in response to higher inflation. CPI for February came in at 2.4% last month. The Flash Estimate for March came in at 2.6% last week. With the ECB single mandate to control inflation, the rate is simply too high for officials being above its 2% target.
When a central bank starts to tighten, it usually is not a “one and done”. As a result, I would expect a gradual series of tightenings that will get the ECB’s point across. Even with the tightenings the inflation rate could still trend higher if oil continues to rise due to supply issues or expectations for supply constraints as a result of mideast tension. Since the ECB is not concerned about core inflation but simply total inflation, the series of rate increases could slow economic growth too much at some point (and be hard on the weak sisters in the EU especially). However, the ECB will likely continue the pressure until inflation does come down.
What may also contribute to slower growth is if the EURUSD continues its move to the upside. Of course a rising EURUSD has the effect of making exports less competitive abroad. So far, Germany has enjoyed a increase in exports as a result of stronger growth in emerging countries. The flight into the CHF has also benefited German exports vs Swiss manufacturers. However, should the EURUSD and EURCHF continue to rise, this too could lead to a more substantial decline in growth… eventually.
What about now? Does the EURUSD have room to rise further?
It certainly is a possibility especially if the US does not start it’s unwinding of economic expansion. Although some Fed officials have recently indicated a desire to take away some of the proverbial “punch bowls”, the market is anxiously awaiting what Chairman Bernanke feels about the unwind idea. Chairman Bernanke is scheduled to speak tonight at 7:15 PM ET, and although he is not expected to comment on economic policy, he may give his views on the recent employment report and his views on the pace of expansion.
Even with a more upbeat assessment, the dollar may still lag. The Fed is likely to stop the non-interest rate components first before lowering rates. The Fed has indicated they could stop the reinvestment of maturing proceeds from QE. That should progress to stopping QE altogther. From there they could increase the reserve requirement on banks before finally raising interest rates. That is a lot of potential steps to unwind before interest rates are changed. Any delay by the Fed and the the EURUSD can easily continue its move to the upside.
That is the fundamental story at least.
The technical story has key trendline resistance above at the 1.4280 level to get through. This level corresponds with a trendline off the July 2008 and Nov/Dec 2010 highs. The level is also equal to the high price from November 2011.
So far the price has been able to stay below the key level (high today reached 1.4267). However, a move above the level coupled with hawkish comments from Trichet on Thurday and/or dovish comments from Bernanke, could lead to the next leg higher in the EURUSD. Be aware.