ECB and BoE Rate Decisions: Scenario Analysis

The two biggest event risks for currency traders over the next 24 hours are the Bank of England and European Central Bank monetary policy decisions. The first up to bat will be BoE, followed by the ECB. Both central banks are expected to leave interest rates unchanged but the tone of their statement and comments can have a dramatic impact on the euro and British pound. As we have seen from the market's reaction to Tuesday's Bank of Canada announcement, talk is not cheap when it comes from a central bank. The hawkish comments from the BoC have driven the loonie sharply higher. Tomorrow, the central question that investors will have for the BoE and ECB is not whether they will be hawkish but how long they plan on remaining dovish.

With that in mind, let us take a look at the possible outcomes for the upcoming interest rate decisions and how the Euro and British pound could respond.

Bank of England Rate Decision (7:00am ET / 12:00 GMT)

The British pound has sold off aggressively over the past few weeks because the Bank of England is one if not the most dovish central bank. They are openly talking about increasing the amount of Quantitative Easing despite the fact that economic data has been mixed since the last monetary policy meeting. Conditions have deteriorated more recently but the weakness is not broad.

Scenario 1: Rates Remain at 0.50%, QE Unchanged, BoE Grows More Dovish > Mildly GBP Bearish

The most likely scenario tomorrow is that the Bank of England will leave interest rates and their Quantitative Easing program unchanged but increase their degree of dovishness. The recovery has been lackluster and consumers have refused to spend. Yet more importantly, the BoE is much closer to increasing their QE program than most people think. According to monetary policy committee member Miles who spoke last week, the central bank's decision to leave the Quantitative Program unchanged was a close call. Bank of England Governor King added that it may be necessary to expand Quantitative Easing especially if growth in the Eurozone falters and even likened themselves to Greece with the only primary difference being that the U.K. has its own currency. Furthermore, the BoE wants to the pound to fall. They have gone to great lengths to talk about how a lower sterling will boost growth which suggests they are banking on a weak currency to fuel their recovery. If the BoE grows more dovish, GBP traders have stronger reasons to sell sterling because they know that the BoE won't stand in their way.

Scenario 2: Rates Remain at 0.50%, BoE Boosts QE > Very GBP Bearish

There is a small but realistic possibly that the Bank of England could boost the size of their Quantitative Easing program. Economic data has been weak and central bankers have noted that their unanimous decision to leave their QE program unchanged was a close call. More QE from the BoE would reinforce their status as the G7's most dovish central bank which will in turn send the pound sharply lower. This would be the likely price action even if they try to temper the market's reaction by suggesting that this would be their last dose of QE.

Scenario 3: Rates Remain at 0.50%, QE and BoE's Tone Remains Unchanged > Mildly GBP Bullish

Given the comments that have already come out of the BoE, we doubt that the central bank will keep the tone of their statement unchanged. However the one thing that could prevent a change is inflation. Consumer prices are above their 2 percent inflation target and above levels that require an explanation to the Chancellor. The services sector also appears to be recovering given the rise in PMI last month and manufacturing should recover if the pound remains weak. Therefore the BoE may have time on their side and could opt to wait another month before formally backing more QE.

European Central Bank Rate Decision (7:45am ET or 12:45 GMT)

The European Central Bank meeting on the other hand is expected to be far less interesting. Although there is still a lot of uncertainty about how the countries within the Eurozone will respond to the problems in Greece, Portugal, Spain and Ireland, the economic climate within the Eurozone has not changed enough over the past month for the ECB to alter their monetary policy stance. In February, ECB President Trichet admitted that EU deficits could "burden" or influence monetary policy. This suggests that until the deficit problems are resolved, the ECB may put off plans to raise interest rates. Yet we expect the ECB to announce additional plans to end their emergency measures. There are only 2 likely scenarios for the upcoming ECB meeting and traders need to remember that the actual interest rate announcement is less important than Trichet's press conference which will begin at 8:30am ET or 13:30 GMT.

Scenario 1: Rates Left at 1.00%, ECB Downplays Concern about EU Deficits, Continues to Phase Out Liquidity Measures

The most likely outcome tomorrow is that the ECB will leave interest rates unchanged, downplay the concerns about EU deficits, applaud Greece for their new austerity package and announce new measures to phase out excess liquidity. In tomorrow's meeting, they could tighten the terms of their last 6 month liquidity measure and scale back their 3 and 1 month operations. The ECB could also announce a return to auction systems for some operations and consider ways to bring their deposit facility which is currently at 0.25 percent back towards their main policy rate of 1 percent. Another step towards the exit should be bullish for the euro and perhaps the latest rally in the currency is a reflection of traders positioning ahead of an expected announcement from the ECB.

Scenario 2: Rates Left at 1.00%, ECB Emphasizes Concern about EU Deficits, Continues to Phase Out Liquidity Measures

Scenario 2 is similar to scenario 1 in that we still expect the ECB to continue to phase out liquidity measures. However in this scenario the ECB emphasizes rather than downplays the impact that EU deficits have on monetary policy. The reason why we think this scenario is less likely is because the ECB announcement comes on the heels of Greece's new austerity package. Nonetheless, if they grow more concerned, the euro could sell-off once again.

The following table illustrates how Eurozone economic data has fared since the last monetary policy meeting.

The EUR/USD's move after monetary policy announcements tends to have follow through according to the following chart which shows how the EUR/USD has performed after recent monetary policy meetings.

Source: GFT DealBook 360