Forex Investment and Currency Trading

ECB clearly ups the hawkish ante…
While delivered with a French accent, this week’s press statement had a decidedly Germanic tone with its clear hawkish leanings redolent of ECB Council uber hawks Weber and Liebscher. The opening paragraph contained a clear threat of higher rates via the insertion of notes that “…inflation is now expected to remain high for a more protracted period than previously thought”, the Bank is “in a state of heightened alertness” and that it will prevent the emergence of second round effects by “acting in a firm and timely manner”. More
tellingly, meanwhile, was the removal of the previous reference to the fact that “the current monetary policy stance will contribute to achieving our objective”.

…underpinned by a deteriorating CPI outlook
The motivation for this hawkish shift was not hard to find. The ECB upwardly revised its CPI projections yet again with the 2008 range rising somewhat significantly from 2.6% to 3.2% in 2008 to 3.2% to 3.6% and
that for 2009 now set at 1.8% to 3.0% vs. 1.5% to 2.7% in March. With the mid-point of these new ranges standing at 3.4% and 2.4% for 2008 and 2009 respectively, the Bank is looking at a clear overshoot of its inflation target through to the end of its policy horizon. Unsurprisingly, these changes reflect the persistently elevated level of global food and energy prices. These const pressures have, however, also
resulted in a somewhat gloomier outlook on the growth front. The lower end of the projected growth range for this year was revised modestly upward as a result of the unexpectedly firm Q1 GDP print (now seen at 1.5% to 2.1% vs. 1.3% to 2.1% three months ago) while growth expectations for 2009 were downgraded to 1.0%-2.0% vs. 1.3%-2.3% previously. Trichet was, however, keen to point out that these projections should
be interpreted with particular caution – this given that they mask a trough in the quarterly growth rates in 2008 with GDP seen recovering through the course of the following year. The message from these comments is clear – the growth profile is not as weak as it might first appear and, more importantly, does nothing to shift the Bank’s firm focus upon its inflation concerns.

The door is clearly open for higher rates
Should the message not have been quite clear enough from the statement, Trichet noted in the wake of the press statement that “it’s not excluded, after having carefully examined the situation, that we could decide to move our rates by a small amount at the next meeting”, adding: “I don’t say it’s certain. I said it’s possible”. Reading between the lines this would support the view that the “heightened alertness” signalled here is a warning that there is significant support for higher rates within the ECB Council but that the majority had yet to sanction a hike – a development that would have been indicated by the insertion of the “vigilance” term. Both the tone of the statement and Trichet’s subsequent comments clearly point to the fact that the Bank believes it has given sufficient forewarning of a rate move but with the outcome of
the next meeting still hanging in the balance.

So what could stay the ECB’s hand in July? The answer may lie in examining why the Bank returned to the sidelines in June 2007. The comparatively elevated degree of capital utilisation as of mid-2007 was, at
least historically consistent with rates rising by a further 50bp. We argue that a de facto tightening of policy in the form of both the credit crunch and the euro’s rapid appreciation pushed the ECB to the sidelines earlier than would have otherwise been the case. With the inflation outlook clearly worsening, Europe seemingly relatively unscathed by the ongoing financial crisis and the dollar in the ascendant, rates at 4.00% is increasingly looking like “unfinished work”. Ironically, however, the credibility of the ECB’s rate hike threat has lit a fire under the single currency thereby seeing the market’s, once again, doing some of the lifting on the Bank’s behalf. This, in turn, might be the desired effect given a hike is politically difficult given the weakness at the region’s periphery while a currency-induced tightening is likely an effective way to cool down Germany’s resilient export sensitive economy. For now, market continue to see European rates on hold through 2008 but with this premised on the euro rising back into the upper half of the USD1.55-1.60 range. Even if rates remain at 4.00% in July, however, the threat will linger for some time, underpinning bearish European RV trades and seeing the curve retain a flattening bias.