The ECB is unlikely to solve Europe's problems

On Wednesday 6th June 2012 the ECB announces its interest rate decision at 1245BST/ 0745 ET and it holds a press conference with President Mario Draghi at 1330 BST/ 0830 ET. We don't expect any change to interest rates at the meeting or for the Bank to extend other policy support to help the struggling Eurozone.

We don't believe that the ECB will be too radical at this month's meeting as ECB head Draghi reiterated during a speech last week that Eurozone governments should do more to stem the crisis. He also added that conditions in the financial markets, particularly the inter-bank lending markets in Europe, are not as stressed as they were in November prior to the Bank's announcement of its LTRO programme. This is true to an extent. While Spanish and Italian debt markets have come under intense pressure in recent months, the core European nations like France, Netherlands, Belgium, Austria etc. have seen their bond markets hold up well during the latest bout of risk aversion. In fact the French-German 10-year bond spread has narrowed in recent months, which is good news since it suggests the two largest economies in the Eurozone are currently unscathed at this stage of the crisis.

The ECB may reiterate its willingness to support Europe's banking sector if credit dries up in future, but we think it will stick to its guns and resist calls to step in to directly help governments. We will be listening out to any reference Draghi makes to Spain's banking sector, but we believe the ECB will leave the re-capitalisation of some weak Spanish lenders up to the EU authorities.

The Bank could cut interest rates; currently they are 1%, a record low for the currency bloc, after some weak growth signals. The manufacturing and services sector PMI surveys remained in deep contraction territory in May and the unemployment rate surged to a record high of 11% in April. Added to that the flash estimate for May CPI fell to 2.4% from 2.6% in April, this could give the ECB more room to cut rates in the future. However, the Bundesbank is a powerful hawkish element within the central bank and it is likely to resist such a move until the sovereign situation deteriorates even further. This is bad news for the periphery since some countries could benefit from cheaper credit, for example, Spain. However, it's not all bad news as the lack of action from the European authorities may weigh on the euro, which could benefit the peripheral economies' export markets (if they manage to stay in the currency bloc, that is).

If the ECB is fairly muted in its response to the crisis this week then the baton is passed to the EU leaders when they meet at the end of June for the next EU summit. ECB inaction combined with the Greek elections on the 17th of this month may leave high levels of uncertainty in the markets in the coming weeks, which could leave risk assets vulnerable to more downside pressure. There was a pre-election poll blackout in Greece from last weekend, which only adds to the uncertainty and increases the chance of a sell-off in euro-based assets. Added to this, Spain issues 2014, 2016 and 2022 bonds for auction on Thursday. Any signs of weak demand for Madrid's debt may cause a fresh bout of risk aversion.

The euro had a dreadful May after it fell 6%. It is now looking oversold from a technical basis. However, the fundamental picture remains bleak and the euro is still sensitive to headline risk - both positive and negative. Earlier this week we saw a return to the 1.2510 prior highs, however this acted as key resistance, and as we lead up to the ECB meeting EURUSD remains range-bound between 1.2450 and 1.2540. However, without remedial action from the ECB or EU authorities in the near-term it is hard to see how this pair can resist further downward pressure. Below 1.2370 opens the way to a retest of 1.2150 then potentially 1.20 - the low from June 2010.

Source: Forex.com

06.06.2012