The Euro is rallying ahead of Thursday’s ECB monetary policy meeting telling us that the market expects ECB President Trichet to say something hawkish. A 25bp rate hike has already been discounted by currency traders, but with the annualized pace of Eurozone producer prices growing by the fastest pace on record, consumer spending in Germany doubling expectations and the German unemployment rate falling to a 14 year low, the ECB may have to reconsider their plans to raise interest rates by only 25bp this year.

The ECB is a central bank that hates surprises and because of that, they always like to prepare the markets weeks if not months in advance of any pending move. That is why they have been telling us that a 25bp rate hike, which would be their first since 2007 is the appropriate expectation for the upcoming monetary policy meeting. They have also been warning that they are not planning a series of rate hikes. However the ECB may have to backtrack on these words given the recent economic reports.

There are 3 possible scenarios for the upcoming interest rate decision that my Currency Analyst Terri Belkas outlined at DailyFX.com.

The most likely is scenario 2 where Trichet hikes by 25 and then signals that additional rate hikes could come. But I would not completely rule out the possibility of a 50bp rate hike.

Scenario 1: +25bps to 4.25%, Trichet Suggest It’s A One-And-Done Deal

While the EUR/USD is likely to jump on the 7:45 EDT announcement of a 25 basis point rate hike to 4.25 percent, any sort of rally will immediately reverse if Mr. Trichet suggests in his post-meeting press conference at 8:30 EDT that the bank has no intention of increasing rates further. This is the most probable scenario, and traders should watch for comments that indicate that downside risks to growth may help to offset upside inflation risks, or notes that “the current monetary policy stance will contribute to achieving our objective” of price stability.

Scenario 2: +25bps to 4.25%, Trichet Signals Additional Hikes

As we mentioned, a 25 basis point rate increase at 7:45 EDT is very likely to spark a EUR/USD rally. However, if Mr. Trichet remains hawkish at 8:30 EDT, EUR/USD may hit 1.60 as traders rush to price in additional rate hikes this year. Comments to watch for include statements that the ECB remains “in a state of heightened alertness”, “the economic fundamentals of the euro area are sound” and notations that risks to price stability have increased further.

Scenario 3: +50bps to 4.50%, Trichet Implies That Is It

A 50 basis point rate increase to 4.50 percent at 7:45 EDT would be the most bullish scenario for EUR/USD, as this sort of move would be entirely unexpected. Hiking by 50bp would help Trichet get a leg up on inflation and this should be positive for the Euro even if he says that 50bp is all that the market will get this year.

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Kathy Lien

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