Currency Implications of BOE, ECB Meetings

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Marc Chandler

NEW YORK ( BBH FX Strategy) -- The Bank of England and the European Central Bank meet this week. There is much speculation that both will alter policy.

We suspect there may be disappointment, but disappointment with the BOE could trigger a bounce in the pound while disappointment with the ECB could see the euro sell off.

The outcome of the Bank of England's meeting will be known first. Based on the dovish cast to the September BOE minutes and some recent comments, there is speculation that the BOE can resume its asset purchase program with a 50 billion pound purchase over the coming few months. This seems to be the consensus.

The risk of disappointment is threefold. First, the September meeting saw only Adam Posen wanting to resume quantitative easing. To go from 8-1 to 5-4 seems like a big shift.

The second risk is that the data haven't been too bad, including employment, manufacturing PMI (September) and nonmanufacturing PMI (August). What's more, inflation ticked up in the most recent report (August) from 4.4% year-over-year to 4.5% on the headline. The core rate rose to 3.1% from 3.0%. The headline rate matches the cycle high.

The third risk to disappointment is the Bank of England's preference for using the cover of its quarterly inflation report to make such announcements. The next one is due in November.

The pound recorded the year's lows, thus far in late September near $1.5330. It bounced into month-end but has run out of steam near $1.5700.

The net speculative position at the International Monetary Market switched to short 64,000 contracts in late September from long 11,000 contracts in late August, suggesting short-term momentum players and trend followers have built a substantial short-pound position.

Some of this reflects the general dollar strength as a safe haven. The failure of the Bank of England to resume its asset purchases could prompt a bout of position adjustment. We also note that end the end of last week, the pound's 50-day moving average crossed below the 200-day moving average for the first time since early September 2010.

Such a short-covering bounce will provide longer-term investors a better level to hedge or reduce pound exposures. We look for the U.K. currency to finish the year near $1.50.

The pound's response to the BOE move or lack thereof, will be influenced, at least in part, by the reaction to the ECB's moves. This week's ECB meeting is the last at which Jean-Claude Trichet will be president of the bank.

The ECB's critics worry that the central bank is blurring fiscal and monetary policy, but the ECB itself draws a clear distinction between liquidity measures and monetary policy. The ECB's focus is likely on liquidity measures. This will likely include another six-month refi and the reintroduction of a 12-month facility.

The ECB may also announce a resumption of its covered bond purchases. It previously bought 60 billion euros of covered bonds in a year-long operation that ended in the middle of last year.

The size of the European covered bond market is estimated at roughly 2.5 trillion euros. This market has come under stress in recent weeks, and this is reflected in the lighter issuance schedule and widening spreads.

If the ECB does resume its covered bond purchases, speculation has centered around 50 billion to 100 billion euros. Rather than easing monetary policy per se, covered bond purchases are likely best understood as another way to inject liquidity.

There had been some thought that the ECB could also widen its corridor (deposit and emergency lending rate), which currently stands at 75 basis points and 2.25%, respectively. However, European contacts suggest that it would not make sense to rewiden the corridor by cutting the deposit rate without reducing the repo rate.

The ECB is most likely to provide new liquidity measures. A rate cut is more controversial. There has been much speculation. At first some were talking about a 50-basis-point cut. However, M3 and private sector lending, coupled with higher-than-expected preliminary eurozone inflation (including an uptick in Germany) have seen many scale back the call to a 25-basis-point cut.

With the eurozone flash composite PMI for Sept coming in below 50 and no real improvement in the final manufacturing PMI, the risk is that the eurozone stagnates or worse. ECB officials should also have confidence that with the dramatic pullback in commodity prices, headline inflation pressures should ease.

Lastly, another wild card is the politics. If the ECB does not cut rates -- and Trichet did not use the code words in September to suggest an October rate cut -- the pressure falls to the next ECB president to begin the easing cycle.

Mario Draghi is the first ECB President from a peripheral country, for which the ECB is already buying its sovereign bonds in the secondary market. It is far from ideal for Draghi to have to begin cutting rates at his first meeting.

If the ECB does cut rates this week, the euro may respond positively as it may be associated with boosting risk appetite, especially ahead of the U.S. jobs report, where the private sector is expected to have created about 90,000 jobs, half of which may be accounted for by returning strikers. A failure to cut rates may be euro negative on grounds that the crisis in the periphery is likely to worse, without easier monetary policy. Indeed both the ECB rate hikes this year triggered new widening in peripheral spreads over bunds.

The net speculative position at the IMM has swung from long 2,500 at the end of August to short 82,400 at the end of September. The stalling of the euro's downside momentum could prompt late shorts to cover, in which case the $1.36-$1.37 area should cap such upticks. On the downside, $1.3150 is our next target, which corresponds to a retracement of the euro's rally since mid-2010, the last time it traded below $1.20. We look for the euro to be near $1.29 by the end of the year.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.