What is the Risk for the ECB? UK Firms Go On Fire Sale

Daily Forex Fundamentals | Written by Kathy Lien | Sep 04 08 08:24 GMT |

WHAT IS THE RISK FOR THE ECB? In yesterday's Daily Currency Focus, we said that the 1.45 level was significant support in the EUR/USD.A break below that level would have opened the door for a move down to 1.42. Even though the EUR/USD did take out the support to hit an intraday low of 1.4385, what was more impressive was the currency pair's reversal. The close back near today's high reflects strength rather than weakness. The European Central Bank interest rate decision is the wildcard tomorrow.The recent decline in the Euro suggests that the market is expecting the ECB to be dovish despite their clearly hawkish rhetoric. Traders are looking at the price of oil and the recent Eurozone economic data and drawing the conclusion that the ECB can no longer be stubbornly hawkish.Second quarter growth and retail sales were both weaker than expect.Although service sector PMI was revised higher, it still remains in contractionary territory. Keeping interest rates on hold at 4.25 percent is a given, but Euro bears may be disappointed by Trichet's press conference.If the ECB is dovish, it would be in line with the recent price action in the Euro, so the risk is hawkishness.The ECB is not a central bank to fade – their job is to stabilize the economy and not to induce volatility.If they say that they are hawkish, there is no reason to doubt them.Recent comments from members of the Governing Council indicate that even though economic growth is slowing, the ECB expects activity to pick up next year.With a strict inflation mandate, they are much more worried about inflation feeding into wage and price setting behavior. Before shifting their stance, they may want to see oil prices remain at current levels for at least another month. BOE TO LEAVE RATES UNCHANGED, UK FIRMS ON FIRE SALE The British pound continued to sell off despite an improvement in service sector PMI.The UK economy is weak, but it is encouraging that manufacturing, construction and service sector PMI all improved in the month of August.This suggests that even though growth is continuing to contract, the pace of deterioration may be slowing.Consumer confidence remains at a 4 year low, but the recent decline in the British pound and the drop in oil prices should help to boost growth.The 12 percent decline in the British pound has put UK firms on a fire sale.We expect M&A activity to pick up, which could help to temporarily stabilize the currency. The Bank of England is expected to leave interest rates unchanged at 5.00 percent.With the economy slowing and inflationary pressures easing, the next move by the central bank should be a rate cut.The market is currently pricing in 75bp of easing over the next 12 months and because of that, we still expect the GBP/USD to break 1.75.Usually when the BoE leaves rates unchanged, no statement is released, which mean that the action should be in the EUR/USD tomorrow on the heels of Trichet's press conference. Kathy Lien http://www.kathylien.com