Forex Investment and Currency Trading

While the storm is raging in financial markets and the US economy teeters on the brink of recession, the European Central Bank is keeping its nerves.

Neither the further Fed rate cut to a mere 2.25% nor the surge in the euro exchange rate to a new lifetime high versus the US dollar has triggered any appreciable shift in the ECB position yet. The ECB is firmly on hold for the
foreseeable future. At least that is the clear message in almost all ECB communications at the moment.

Although a few cracks in the strong ECB posture may be starting to appear, these cracks are still tiny. Despite the tough ECB stance, market maintains the view that there is a better than even chance that the ECB will eventually change course and ease rates modestly over the summer, probably starting in either June or July.

Market believe that the Eurozone economy will perform less well in mid-2008 than the ECB projects before rebounding nicely in 2009. If so, a further downward revision in the ECB staff forecasts for growth in June 2008 could lay the basis for an eventual rate cut. But until the data turn south, the ECB will likely maintain its current stance.
After its March council meeting, the ECB sent out one clear message: rates are firmly on hold for the time being. More precisely, the ECB emphasized that “the current stance of monetary policy will contribute to achieving (the) objective” of maintaining price stability by firmly anchoring inflationary expectations.

ECB hawks have a number of good reasons for such a posture. So far, the hard economic data for the Eurozone are holding up well. If anything, the area had a good start into the first quarter with an 0.9% monthly rise in industrial output, a 1.6% surge in construction output and a 0.3% rebound in retail sales in January.

Although a slump in January car registrations caused largely by a new eco tax in France clouds the picture a little, the ongoing decline in unemployment (from 7.2% in October and November to a fresh 18-year low of 7.1% in December and January) highlights the underlying strength of the economy.

In addition, credit growth remains buoyant, with no clear evidence yet of any genuine credit crunch, that is of a severe restriction of credit to worthy borrowers. In addition, the 9.5% year-on-year rise in Eurozone exports in January and the fact that Airbus secured a major US defense contract against fierce competition from Boeing show that last year’s rise in the euro exchange rate has not yet put an end to the export boom.

At the same time, headline inflation hit 3.3% in February, the highest level since the mid-1990s. Amid ever more signs that German workers will be able to push through wage increases of close to 4% this year after less than 2% last
year, the ECB hawks have reason to worry about the inflation outlook.

In this context, the sharp correction in implied futures for 3-month money market rates for September 2008 from a low of 3.43% on 8 February to 3.93% on 19 March makes sense.

The reasons why the ECB may rethink its current stance over the next few months are largely obvious, but still worth spelling out.

• With its explicit and repeated affirmation of its current stance in the March statement, the ECB Council has apparently found a wording which it expects to maintain for a while. But the ECB also acknowledged heightened uncertainty. In addition, experience shows that the ECB can be quite flexible. The bank changed its message at almost each meeting since July, for instance by veering from a very hawkish tone in January to a surprisingly dovish stance in February and back to a moderately hawkish outlook in March. In these uncertain times, ECB words are clearly not cast in stone.
• With the collapse of Bear Stearns, the global financial crisis has taken a turn for the worse, dashing hopes of an imminent return to more settled market conditions. Although Eurozone consumers are less sensitive to equity market gyrations than US consumers, the 20% year-to-date fall in the Eurostoxx 50 index (-19.8% on the evening of 19 March) will probably retard any revival of consumer spending by 0.1-0.2% on late 2008 and early 2009.
• The euro trade-weighted exchange rate has risen by 4% relative to its November/December 2007 average and is now roughly 3.5% higher than the ECB had assumed in its March 2008 staff projections. If not corrected, this could, by weighing on net exports and business investment, reduce the pace of GDP growth in late 2008 and early 2009 by 0.2-0.3% points.

As a result, ECB staff members may cut their projection for Eurozone growth in 2008 from a midpoint of 1.7% to no more than 1.5% at their next update in June. This should be reflected in a lesser degree of capacity utilization and some easing of inflation pressure next year. If so, the ECB could shave its 2009 inflation forecast from a mid-point of 2.1% to 2.0% or 1.9%. In turn, this could open up the leeway for modest rate cuts over the summer in the context of an ongoing financial crisis.

The case for lower ECB rates is not clear-cut. Market merely see a 60% probability that the ECB will reduce rates at all this year. For next year, market forecasts a significant rebound in the US economy, the US dollar and Eurozone growth, triggering a reversal of Fed rate cuts and a rise in ECB rates from 3.5% to 4.75% over the course of 2009.

Over the last few weeks, the hawks within the Governing Council have been very vocal. Bundesbank President Axel Weber, the undisputed leader of that pack, may be disproportionately impressed by the strong showing of the German economy lately, which may not give an accurate image of the Eurozone as a whole. For instance, the preliminary composite PMI index fell almost one point on the month to 51.9 in March in the Eurozone, while both the manufacturing and services PMIs rebounded in Germany.

Doves are now starting to speak up, albeit very discreetly. Banque de France Governor Noyer paid dues last week to the ECB’s current tough talk but also insisted that no second round effects could be evidenced so far. He also mentioned that “the room for monetary policy decisions could be restricted by the state of the financial and banking system and by the risks of a slowdown in growth”. It may not be much, but it could be the sign that the wall of China which the ECB has built between money market rescue, on the one hand, and monetary policy on the other hand, may be slowly cracking.