The European Central Bank will make its May monetary policy decision after a meeting of governing council members in Barcelona tomorrow.
Analysts do not predict any change in rates from the current target of 1.00 percent, based on some hawkish statements we've heard from ECB President Mario Draghi during the last few weeks.
However, this is also the first time in months when the thought of a rate cut has not been an impossibility. The eurozone economy is undoubtedly slowing, economic activity is contracting, and the inflation rate has slowed from 3.0 percent late last year to an estimated 2.6 percent in April.
On the other hand, measures of M3 money supply—one of the most important indicators for the ECB in gauging the pace of inflation—is still expanding, spelling caution ahead for the bank. Take a look at M3 below:
Interestingly enough, a hold on rates might actually be bearish for the euro and a cut positive. This defies general forex logic, since generally a rate cut is expansionary, thus leading to a weaker euro.
Citi's Steve Englander explains this anomaly:
The conventional view is that ECB ease will weaken the euro, just as speculation about additional stimulus measures hit the USD recently. As straightforward as this view is it is probably not correct. The recent euro weakness reflects stresses on sovereign debt, exacerbated by economic weakness. FX market concerns are that Spain and Italy will enter into a downward economic and financial spiral, not that the ECB will be excessively expansive in its policies... So if the ECB surprises with a policy rate cut, the euro may fall anyway because FX investors will see it as an ineffective policy move, unless they imply very strongly that this is a first installment on more aggressive policy moves down the road at the long end.
However, there are a handful of ways that the ECB could move markets: particularly through hinting at another three-year LTRO or announcing a restart in the Securities Markets Programme, through which the ECB has previously purchased sovereign bonds from Spain, Italy, Ireland, Portugal, and Greece in order to keep yields low.
If they hint at another 3yr LTRO, there may be limited enthusiasm because the impact of the first two was limited in duration and degree. A longer LTRO – which does not seem to be in the cards – would be more supportive of the euro. By contrast, if they signaled that SMP buying would resume, we think the euro would rally, as the policy would spark expectations of relief at the long end of peripheral debt, where the problems are concentrated. A hint of such a move was given by a Governing Council member a few weeks and the euro rallied significantly on the news. We think this would be the single most euro positive measure that could be taken. That said, our economists do not expect SMP buying in any large scale.
Either way, the fact that monetary policy is influencing currency markets in a counterintuitive manner indicates increasing worries about the viability of the euro moving forward. No longer are investors concerned that the ECB's policies might make the currency slightly stronger or weaker, they are concerned that the bank will not take appropriate actions to ensure the very survival of the currency.
And the more analysts doubt the stability of the euro currency, the more we'll hear negative reverberations across asset classes.
DON'T FORGET: 12 Things You Need To Worry About In Europe Right Now >
More From Business Insider
- After A Full Day Of Protests, Occupy Reached Liberty Square, And Some Protesters Don't Want To Leave
- Selena Rezvani Gave These Smart Negotiating Tips To LinkedIn Employees
- These Are The Most Fashionable Towns In America