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By Kathleen Brooks | May 3, 2012 2:04 PM IST

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On Thursday 3rd May at 1245 BST/ 0745 ET the European Central Bank (ECB) will announce interest rates. It is widely expected to remain on hold at a record low 1%, for the fifth consecutive month. Of more importance to the market will be ECB President Draghi's press conference at 1330 BST/ 0830 ET as we will likely find out the Bank's view on weakening economic growth and sovereign strains in Spain. Draghi may also shed more light on the "growth compact" that he suggested at a speech to the European Parliament last week.

We don't believe the Bank will announce any new "special" measures to try and ease the problems in the Eurozone periphery. President Draghi did not hint in his speech last week that the Bank would re-start its Securities Markets Programme (SMP), which purchases domestic sovereign debt, and we don't expect another round of the controversial LTRO loans for banks. While Draghi hinted that the Bank could be more accommodative in the same speech, he didn't give any details on how it would do this and we tend to think that the Bank may wait until June to announce any further measures as this is when the next ECB staff forecasts on growth and inflation are due to be released.

However, we do expect Draghi to open the door to further accommodative policy measures by highlighting the Bank's concern at the deteriorating growth back-drop for the currency bloc. Unemployment in Spain rose to nearly 1 in 4 in the first quarter, and the Spanish economy slipped into a double dip recession at the start of this year. Overall, the economy had a weak start to the second quarter according to the April PMI surveys. The manufacturing, construction and services sector surveys all fell to multi-month lows. The Eurozone Composite PMI is back at November 2011 lows, when Spanish and Italian bond yields reached euro-era highs. However, there is a two-speed economy within the currency bloc, with Germany doing well and the periphery struggling. We expect Draghi may temper his concerns that weak growth could threaten deflation as underlying inflation pressures have recently been rising in Germany. The extent to which he sounds worried about price pressure may determine how "hawkish" the market perceives his speech to be.

Last week Draghi hinted at the prospect of a growth compact to run alongside the fiscal compact, which was also supported by German Chancellor Merkel. We may hear more a potential structure for a growth pact at this meeting; especially since market concerns are growing that fiscal targets imposed by Europe are eroding economic growth in the region. Added to this an austerity backlash has emerged within the currency bloc. French Presidential candidate Hollande is basing his election campaign on re-negotiating French fiscal targets, the Irish go to the polls on the Fiscal Pact at the end of this month and the Dutch government collapsed after it failed to reach an agreement on cutting the fiscal deficit last week.

While the markets would like some radical action to boost growth across the currency bloc, we think that Draghi could be more muted due to Germany's insistence that economic reform and fiscal austerity must run in parallel. Thus there is a risk that the market could be disappointed, especially if it looks like the ECB is unwilling to intervene in a forthright way to boost the economies of peripheral Europe.

Market impact:

 

We believe that a very weak economic backdrop and no firm action from the ECB to help Europe's struggling peripheral economies, especially Spain, along with election risks in France and Greece this Sunday could weigh on the euro in the medium-term. EURUSD has been trading in a fairly tight range between 1.3150 and 1.33 in recent weeks. Yesterday we saw EURUSD fall quite sharply on the back of some weak economic data, especially out of Germany. The market may have also been pricing in some dovish comments from the ECB today on the back of the deteriorating economic back drop.

If Draghi disappoints the markets and is not as dovish as some expect then we could see investors immediately sell the euro, as a lack of ECB action could make the economic and sovereign situation even worse. 1.3110 - the base of the daily Ichimoku cloud - has acted as fairly good support for now. However, the longer-term outlook for this pair is a battle of the central banks. If US economic data continues to outpace the Eurozone then we may see EURUSD come under sustained pressure as the Fed moves to a more neutral stance while the ECB remains accommodative.

If Draghi does announce new stimulus measures today (something we don't expect) this could have an immediate knee jerk reaction and cause the euro to weaken. However, if it reduces credit risk in the currency bloc then the euro could break out of the top of its recent range at 1.3330 in the medium-term. In January and February this year we saw the euro strengthen vs. the dollar as the LTRO programme was deemed to have stabilised the sovereign situation even if it expanded the ECB's balance sheet to record levels. Thus, more stimuli in the currency bloc doesn't necessarily mean a weaker euro.

We believe that EURGBP will continue to grind lower and could come under pressure if the economic and sovereign situation continues to deteriorate. However, we don't see this pair moving sharply in either direction until we get the latest growth and inflation projections from the Bank of England in its next Inflation Report scheduled for release on 16th May. A 0.8050 - 0.8200 range may persist until then.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957  | e: kbrooks@forex.com| w: www.forex.com/uk

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