The EUR/USD is susceptible to Dovish ECB Guidance amid German Court Ruling. Some believe that these actions by the Bundesbank have affected the EUR/USD price action. Here are my thoughts.
The European Central Bank recently sent mixed signals with regard to the ability of its “quantitative easing” (QE) program to stimulate the real economy.
One signal was the QE-1 program. This program offered one billion euros in cash to banks for every one billion invested. Although banks have been successful in investing the money and increasing their balance sheets, this policy has not been well received by the market as a whole.
To avoid over-extending itself, the European banks and countries are still hoping for a second signal from the ECB. As expected, the European central bank will provide this signal. This second signal will need to be interpreted very carefully by the market and should not provide too much stimulus.
Dovish ECB Guidance by the ECB may influence the market but it will not necessarily provide any stimulus. There are two aspects to take into consideration. One, the price action can either be exogenous (produced by outside factors), or endogenous (contributing to the dynamics of the market).
Exogenous effects usually have a lower impact on price movement than endogenous effects. If the price action is exogenous, this means the signal comes about because of something other than monetary policy. The exogenous signal can be a change in market expectations. This is similar to the exchange rate signal that occurred with the third policy (quantitative easing) and the second policy (plunge protection). For example, because the European Central Bank increased its benchmark interest rate during this time, the European banks increased their deposit rates, thereby reducing the capital-market funding requirements. Alternatively, the banks might raise their own liquidity buffers. This would cause them to seek out more funding, which would reduce the available liquidity position. These additional liquidity requirements would result in a reduction in the available spread over the ICEF.
In currency trading, the market participants are unable to influence the transmission mechanism for the exogenous and endogenous signals. At most, they can anticipate the change in market expectations. This can be accomplished through the use of inbuilt market indicators and methodologies.
The market participants could also go beyond the basic market indicators by predicting when the ECB’s next policy will be announced. They could do this by conducting a technical analysis of the market for market data and either formulating their own analytical techniques or hiring private consultants. This kind of analysis can be quite time consuming.
Dovish ECB Guidance by the ECB might provide an additional signal to the market and this could provide the market participants with the additional incentive to employ more aggressive trading strategies. This would again help to stimulate the price action, but not necessarily provide a response to the exogenous policy. Instead, a more complete response to the exogenous policy might be provided by the final policy announcement.
Dovish ECB Guidance by the ECB would provide the market participants with a signal, but this signal is probably not going to be the one that they would like to hear. Because the ECB has not made an announcement on whether or not it intends to eliminate its stimulus program, it is hard to tell at this point what the final policy decision will be.
Perhaps one more signal worth watching is the EUR/USD price action. Currency traders in both the US and the Eurozone will be watching the EUR/USD price action very closely. In Europe, large holders of Euros such as hedge funds are likely to be concerned about what the ECB may announce regarding its QE program.
Dovish ECB Guidance by the ECB might provide the market participants with the first signal about the ECB’s next step in reducing its stimulus program. However, the final policy decision will be determined by the final policy announcement.