Will ECB prepare markets for a rate cut

Investors will be paying close attention to the European Central Bank’s tone and indications on interest rates outlook today. Ahead of the publication of the ECB’s latest policy statement and President Mario Draghi’s press conference, the euro was largely out of favour this morning after it reversed sharp gains to close lower yesterday. Stocks were still buoyed by increasing signs that central bank policy outlook has taken a decidedly dovish turn.

Will ECB join race to the bottom?

Nearly all major central banks have made U-turns on interest rates over the past few months, dropping their previously hawkish stances in favour of more expansionary outlook and the ECB will be no different, in our view. Although no change in interest rates is expected at this meeting, some market participants clearly anticipate that the ECB will be preparing the markets for a potential rate cut at some point down the line, possibly early next year. Just a few months ago, they were contemplating on an interest rate hike after the end of this summer. However, things have changed for the worse in recent months, with protectionism on rise, the global economy slowing down and there is still no light at the end of the Brexit tunnel. Meanwhile renewed weakness in crude oil is likely to be an additional disinflationary factor that policymakers at the ECB would be taking into account.

How will the market react?

But as always, it is the market’s reaction that will be more important than the news itself. It is reasonable to expect that some shrewd investors will already be anticipating the ECB to deliver a dovish outlook on the economy and interest rates. So, some of the ECB’s likely dovishness may already be priced in and therefore we might not see too much of a reaction in the euro or stock markets. Indeed, the bigger risk as far as the markets are concerned is the event the ECB turns out to be surprisingly less dovish than expected. Now that would be a real surprise given the cooling of inflation and anaemic growth in the Eurozone, not to mention ongoing Brexit and trade uncertainties.

German-Japan yields narrowest since April 2015

Among the euro crosses that we will be watching during and after the ECB presser will be the EUR/JPY given the recent narrowing of the gap between German and Japanese yields. In fact, the 10-year German bunds are yielding lower than the equivalent Japanese debt, with the gap falling below zero. At -0.109 currently, the gap is at its narrowest since April 2015 and it could shrink further should the ECB deliver a particularly dovish message today.

Source: TradingView and FOREX.com.

EUR/JPY trends lower inside bearish channel

As far as the EUR/JPY is concerned, well this pair has been trending lower like the abovementioned yield spread and is currently residing in the middle of its bearish channel, hovering around 121.50 support. A clear break below this level could pave the way towards the lower support trend of the channel and possible the January flash crash low at 118.80. However, in the event rates break out of the channel at 112.25 and hold above, then in that case we could see a reversal in the bearish trend.

Source: TradingView and FOREX.com.