ECB to Cut Rates to Record Low?

The Asian and most of the European markets might be celebrating Labor Day today, but that doesn’t mean that you shouldn’t start preparing for the European Central Bank’s interest rate decision happening tomorrow at 12:45 pm GMT!

For the first time in ten months the ECB is expected to slash its minimum bid rate from 0.75% to 0.50%. And why not? Wasn’t it just last week when European Commission President Jose Manuel Barroso hinted that the recent austerity measures have already done their part? Even ECB head Mario Draghi revealed that there was “extensive” discussion of a rate cut during the central bank’s April 4 meeting.

The equities markets seem to reflect this expectation. Notice that European stocks have been rallying ahead of the ECB statement. Many believe this suggests that investors are expecting further stimulus from the central bank.

In fact, some even say that the ECB could cut its deposit rate, the rate at which banks park their money with the ECB, from 0.0% to a negative figure. This would effectively penalize banks for keeping their money with the central bank and force them to lend it to the public.

It’s no secret why calls for a rate cut have gained momentum in the markets. For one, manufacturing and services sectors in key areas such as Spain, France, and Italy, have continued to disappoint. Even Germany, the region’s largest and strongest economy, has been showing disturbing signs of weakness. And need I mention that Spain’s unemployment rate is at a new record high?

But the euro zone doesn’t stand to gain on the domestic front alone. Cutting rates could weaken the euro and give its exports a much needed boost in the global markets as well.

As we learned from the School of Pipsology, interest rates are one of the key fundamental factors that affect currency prices. Cutting interest rates would help remove some of the euro’s luster and sap demand for the shared currency.

But why would the ECB be interested in doing this?

Well, for one, the euro has managed to defy gravity and trade higher in recent weeks, in spite of the economic and political problems that have been plaguing the euro zone. A weaker euro might finally give the euro zone and its exports a chance against the U.S. and Japan, two countries that have adopted open-ended QE (which have contributed to USD and JPY weakness).

4 Possible Outcomes

The way I see it, there are four possible outcomes for the ECB rate decision.

  1. The ECB slashes both the minimum bid rate and the deposit rate. This is perhaps the most aggressive step the central bank could take. Such a move will most likely be extremely euro bearish. Expect the markets to dump the shared currency like there’s no tomorrow.
  2. The ECB slashes the minimum bid and hints at further easing. The euro will probably sell off strongly and could come under extended selling pressure, depending on what sort of measures are brought up.
  3. The ECB slashes the minimum bid and doesn’t hint at further action. Expect an initial selloff, but not an extended drop. Many believe that the markets have already accounted for a rate cut, so this move probably won’t come as much of a shocker.
  4. The ECB does nothing. Anticipate a wild euro rally as those who were expecting some sort of easing would be greatly disappointed. Pay close attention to the accompanying statement, as it could also indicate whether the ECB plans to do something in the near future or not.

But then again, those are just my two cents on the matter. What do YOU think will happen when Draghi makes the big announcement tomorrow?