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European interest rates: growing uncertainty

01 May 2008

Trading Euribor:
The Macro Trader’s view:
While the Fed has furiously been cutting interest rates to try and protect the US economy from what many feared could be the worst recession since WW11, and the Bank of England has eased rates lower in a balancing act between fighting inflation and protecting against feared economic weakness, the ECB has sat on the fence.

The ECB has been torn between two equally pressing forces:
- The threat of economic weakness arising from the Sub-prime/credit crunch crisis, and
- Rising inflation fueled by sky high energy prices and the biggest bull market in commodities generally since the 1970’s.

However, over recent weeks Eurozone policy makers have become increasingly uneasy over inflation as Euro zone CPI hit 3.6% and looked like going higher. With the German economy motoring along and inflation there also pushing up, traders judged the ECB would soon hike interest rates, sending Euribor back towards the lows seen last August, when they were poised to hike, until the credit crunch struck.

The ECB has fuelled speculation they are prepared to tighten with several council members using hawkish rhetoric.

But just as the stage seemed set, inflation has turned lower:
- In the Euro zone CPI declined to 3.3%, not only below the recent high but also under the market consensus, and
- In Germany, the situation has improved with CPI coming in below consensus at 2.4%.

With oil prices suffering a significant drop this week the ECB is faced with a fresh conundrum: what to do with rates at this month’s policy meeting. Based on the latest evidence we think they will stay their hand.

Last week’s German IFO was weaker than expected and Euro zone M3 was mixed, and although the Euro has eased away from the highs, a rate hike looks less urgent than it did only a week ago.

What this means for Euribor is increased uncertainty.

The economy has cooled a little, but the threat from the credit crunch may yet have a greater impact than seen to date, and if inflation has turned and oil prices have topped out, (look at the gold market, the traditional hedge against inflation, it has sold off heavily over the last two weeks) policy makers may be well-advised to continue their long spell of inactivity, leaving traders guessing their next move.
However, unless growth really cools fast, we judge Euribor will struggle to rally. The Fed cut interest rates yesterday and left all of its options open: the policy statement wording was tweaked just enough to place a question mark over June’s meeting, but not enough to proclaim a pause. Thus, another source of uncertainty was introduced.

The Technical Trader’s view:


There is no powerful structure at work in the long-term chart. There is no ruling pattern.

But the fierce reversal and higher recent volatility is clear.

Look closer.

Nor is there much clarity in the week chart.

The market’s bounce off the horizontal at 95.6950 is interesting... if that level were to break now there might be a Head and Shoulders Top in place.

(But that is pure conjecture.)

Look closer still

But here we have a little more to go on.

The important diagonal resistance will be difficult to break up through.

Note the conjunction of Horizontal and diagonal levels.

Only if the falling diagonal is broken as well will the bulls get any real enthusiasm.

In the medium term the bears have the upper hand (despite the recent bull move from a very oversold state) but there are few clear technical pointers suggesting continued uncertainty.

Mark Sturdy
John Lewis
Seven Days Ahead

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