The ECB’s Big Surprise

Last week, the ECB shocked the markets with a surprise interest rate cut. According to Bloomberg, just 3 out of 70 economists expected such a move. Only the Bank of America, UBS and the Royal Bank of Scotland predicted that an interest rate adjustment was a possibility. As the news came to fruition, the EUR/USD fell the sharpest in nearly two years, amassing a near 200 pip drop within an hour. This makes it compelling to gather an understanding as to what triggered such a surprise tactical change.

There has to be something that prompted the ECB to move so proactively in amending their monetary policy.

Worries over deflation:
Consumer Price Index fell to a lowly 0.7% in October, well below the ECB’s 2% target. According to The Economist, one year ago, CPI equated to 2.5%. This is a substantial drop, and the ECB is now anxious about potential deflation. Deflation is also a worry for the United States and Japanese economy.

Firstly, deflation is a concerning issue because once consumers realise that prices are falling, it is likely any consumer would delay making purchases. This would obviously be detrimental to the EU recovery, as it would lower consumer spending levels.

Secondly, if an area in the world has high unemployment (like the EU) and deflation becomes a problem, there is a likelihood that wages will decrease as a result. Eventually, nominal incomes will slow down and government and household debts will become tougher to pay off.

Investor confidence improving, but investment declining:
Investor Confidence has increased over the previous couple of months. In August, Investor Confidence improved from -4.9 In July, to 6.5 in August. In September, Investor Confidence scored a 6.1 and in October, an impressive 9.3.

However, business investment is not showing the same correlation. In fact, since 2007, business investment throughout the EU has contracted by over 25%. The Financial Times have illustrated that in Spain, business investment has decreased by 40% and in Italy, close to 27%.

Despite Investor Confidence improving, corporations are still very cautious and vigilant towards investment and business expansion.

Record high unemployment:
According to the European Commission, the EU unemployment will remain at record high for the next two years. Unemployment is set to remain at a minimum of 12.2% until at least the end of 2015, when it is then expected to drop to a mediocre 11.8%.

It is accurate to suggest that with this interest rate cut, Draghi and the ECB are internally hopeful regarding business investment increasing, in order for new jobs to be created.

Has much leverage does Draghi have left?
The ECB has made a very bold move. Draghi has previously been emphatic that a EURUSD that is valued with the 1.36 range could have an adverse effect on the EU recovery. However, as we have seen very recently, you can never predict the direction of the USD.

If the USD does weaken again in a month’s time, when the debt ceiling negotiations recontinue, Draghi no longer has much leverage, or playing cards at his disposal to prevent the EURUSD surpassing those alarming 1.36 levels.

Quantitative Easing will inevitably never be an option for the ECB, because the Deutsche Bundesbank will never allow it.

Final thoughts:
In conclusion, there is no disputing that the ECB shocked the markets on Thursday. The sudden devaluation of the EU currency is evidence of that.

However, onlookers must be concerned as to what made the ECB act so soon. After all, bearing in mind the USD strengthened substantially after their own impressive metric data, there is no reason to suggest the EURUSD wouldn’t have fallen as sharply as the AUDUSD and NZDUSD had done so, without the rate cut.

Could this upcoming Thursday’s EU GDP release be set to disappoint?

Written by Jameel Ahmad, Research Analyst at Blackwell Global.
Follow Jameel on Twitter @JameelAhmadFX