ECB Adds 25 Basis Points, What’s Next?

On April 7, 2011, European Central Bank (ECB) President Jean-Claude Trichet and his merry men finally caved in to inflation pressures and decided to raise interest rates by 25 basis points to 1.25% — the first rate increase of the ECB in almost three years!

If you look at EUR/USD‘s price action after the report, you’ll see that, while there was some volatility, it certainly wasn’t as extreme as those that followed the previous statements.

According to the School of Pipsology, rate hikes are normally bullish for the domestic currency. If that’s so, then why didn’t the decision cause the pair to skyrocket? If you’ve been following the headlines lately, you’d know that everyone had already been expecting a 25 basis point rate hike.

This means that market participants had already priced in their expectations by buying up the euro before the actual statement. When Trichet finally announced their decision, there just wasn’t any oomph left in the market to take the pair higher!

President Jean-Claude Trichet‘s less hawkish tone also capped the pair’s climb. While he did assure the market that the bank would continue to monitor inflation closely and make appropriate changes to interest rates, he also said that the rate hike wasn’t indicative of future interest rate hikes. Trichet was careful not to promise to anything. It’s kinda like how Big Pippin would talk to girls: smooth while reminding them of his unfortunate inability to commit.

What’s next for the euro?

It looks like the ECB is stuck between a rock and a hard place. In theory, the only driving force behind their decision making process should only be maintaining price stability. Don’t believe me? Check the ECB’s website for yourself!)

But these are unprecedented times, and simply raising rates to tame inflation could have serious negative side effects on a very DIVERSE economy that’s set to grow by a measly 1.7% this year.

If they don’t hike rates, then they run the risk of running into an inflation spiral where workers demand higher wages to compensate for rising prices. This is especially true for Germany.

On the other hand, if they continue raising interest rates, Greece, Portugal, and Ireland will have an even harder time servicing their debts! While there’s a ton of money in the bailout to make interest payments on debt, it won’t last forever.

I’m going to get a lot of flak for this (similar to how football fans are bashing Liverpool FC for letting Lebron James buy part of it!), but I’ll go out on a limb to say that EUR/USD could be nearing a top.

The market seems to have priced in as much as three interest rate hikes and the move looks severely overdone. This price behaviour, coupled with the Irish banking mess, Portugal’s bailout request, and the possibility of a Spanish bailout could lead to a wide-reaching case of risk aversion out of the euro… Yeah, I said it!