ECB Biting the Bullet

There is an eerie quiet in FX markets since the start of the European session as investors wait for the hotly anticipated ECB rate decision and press conference with Trichet due to take place at 1330 BST.

This has trumped any fears about Portugal, which is locked in talks to get financial assistance after a bond auction held yesterday pushed 12-month borrowing costs to record levels. While we still don’t know the exact details on the bailout it appears that it will be somewhere in the region of EUR80bn, similar in size to Ireland’s loan, and will cover Portugal’s financing needs until 2013.

Although the euro has come off its high and is currently below 1.4300 versus the US dollar, we don’t think this was a reaction to Portugal’s news. Instead the euro has come back a bit after investors’ took some profit in response to the single currency reaching a 14-month high versus the greenback.

In our view, Portugal will be the last domino to fall in Europe’s periphery. This will reduce the pressure on the smaller Iberian nation which has EUR11bn of debt to re-finance between now and June. Thus, we do not expect today’s news to spur contagion. In fact, Spain – once considered in the firing line of the bond vigilantes - held a debt auction today and its borrowing costs actually fell as news of Portugal’s request for assistance was still hitting the airwaves. Spain sold EUR4.13bn of 3-year bonds this morning with an average yield of 3.568% versus 3.592 per cent when it staged a similar auction last month.

This gives the euro a good foundation as we head towards the ECB meeting. We think that Trichet will remain fairly hawkish during his press conference as inflation pressures continue to build. Although he may not use the phrase “strong vigilance” we think that he will continue to talk tough on inflation and will remain committed to squashing inflation pressure going forward. We are in line with consensus and expect a further 2 rate hikes this year (after today). This should keep the euro well supported and it may trade to the 1.4350 recent highs. On a longer-term basis until we get more clarity on the where the Fed is heading with interest rates then we think the euro may continue to trade with an upward bias.

A stronger euro today could well put further upward pressure on commodity prices. UK oil has come off its highs this morning as the dollar has regained its poise. This has also weighed slightly on the gold price. However, we continue to think the direction of prices for these commodities is higher at least in the short term.

GBPUSD has also lost some of its shine today and is currently below 1.6300, after the Bank of England kept interest rates on hold. Will they hike rates next month? That is what the market expects. Now that the ECB is set to move first it makes it easier for the BOE to hike, yet we are still concerned that the UK economy won’t be able to handle higher rates at the same time as austerity measures start to bite. Something has to give and right now we don’t think it will be George Osborne.

Source: Forex.com

07.04.2011