Euro Gains Despite Easing Producer Prices, How Deep Will ECB Cut Rates?

12/03/2008 10:24 am EST

Focus: FOREX

The euro rallied over 100 bps after the release of the euro zone October producer price report. The single currency found support despite factory gate prices falling 0.8%, which was greater than the 0.3% that economists had predicted. Slowing growth and falling energy prices would drag the annualized rate to 6.3% from 7.9%, which is the lowest since April. Looking at the breakdown, we see that falling energy prices are beginning to filter through to other areas as the cost for intermediate goods dropped 1.0%.

Abating price pressures will give the ECB the room to continue their current easing policy with economists predicting that the central bank will cut rates by 50 bps on Thursday. The markets have been calling for more aggressive monetary policy action as the region has slipped into recession and has seen manufacturing activity fall to a record low. Yet, recent rhetoric from MPC members has signaled that they will continue their measured approach as they adhere to their mandate of price stability. However, Credit Suisse overnight index swaps are pricing in 141 bps of rate cuts over the next 12 months, as traders believe that it is inevitable that more cuts are coming. Therefore, we may see the euro continue to remain range bound until we hear president Trichet’s comments following the policy action.

The pound remained under pressure during the overnight sessions despite a brief rally on the back of positive equity markets. The expectation that the BoE will cut rates by 100 bps has remained a weighing factor for the cable. UK construction activity falling to 31.8 from 35.1—the lowest level since records began in 1997—is a clear sign that the UK economy is headed for a deep recession. Recent global growth fears have started to undo the coordinated efforts to lubricate credit markets, which may prevent a housing market that is in its worst slump since the Great Depression from turning around.

The RBA cut their benchmark rate by 100 bps, which was more then the 75 bps that the markets were expecting. However, the Australian dollar rallied on the news as central bank governor Stevens signaled that this may be the end of their current easing cycle. The fourth rate cut in as many months brings the benchmark rate to 4.25%—the lowest since December 2001.

Speculation that $150 billion will be invested in US banks by the US treasury through the TARP plan has Dow futures pointing higher and the dollar under pressure. A relatively empty economic calendar will leave price action at the mercy of risk winds, and after Monday’s historic sell off, we could see a subsequent bounce in equities. Hank Paulson is scheduled to speak today, and the US Treasury’s comments always present event risk, especially if he confirms the rumors of the direct investment in US banks. However, the downside risks remain to the global economy, and until traders are certain the worst is behind us, the dollar will remain supported, which will limit its losses in the near term.

By John Rivera, Currency Analyst, DailyFX.com

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