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The ECB's hard call: More stimulus?

April 1, 2014: 7:00 AM ET

The euro is trading lower as investors try to guess whether the ECB will reveal new stimulus.

As worries about deflation rear their ugly head in Europe, investors are debating whether the European Central Bank will act to prop up the continent's economy.

The euro has weakened against the dollar lately as some currency traders bet that concerns about low inflation will prompt the ECB to announce more stimulus on Thursday. The ECB already has its key interest rate near zero.

Others weren't so sure.

"The ECB is more likely to talk than act," said Societe Generale's Kit Juckes.

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Data Monday showed that the annual rate of inflation in Europe fell to 0.5%, down from 0.7% in February.  Inflation is now at its lowest level since November 2009.

There are clearly some headwinds for the European economy, and plenty of people are hanging on to every word ECB chief Mario Draghi says.

Last week Draghi said the ECB remained committed to fighting deflation. Foreign exchange traders took that as a sign that the ECB could unveil plans for more economic stimulus. And low inflation data from Germany and Spain last week also fueled the stimulus speculation.

That talk has been playing out in the currency market. One euro is currently trading at around $1.38, down from just under $1.40 in the middle of March. That may not sound like a significant difference. But it is in the world of currencies.

Further monetary easing, or so the theory goes, would drive down the euro and therefore boost exports as the cost of production cheapens. At the same time, inflation should pick up as more money is pumped into the financial system.

But whether the ECB will actually announce new stimulus is anyone's guess.

"A weaker euro is desirable now," said Marc Chandler, a foreign exchange analyst with Brown Brothers Harriman. He added that despite the recent drop, the euro is still relatively strong compared to other currencies. The mid-March peak against the dollar was the strongest it's been since October 2011.

But Andrew Milligan of Standard Life Investments doesn't think the ECB will make any big policy announcements Thursday. Rather, he said Draghi may have been trying to talk the euro down without having to take action. He feels Draghi was assuring the market that he has the tools combat deflation, even if he doesn't plan to use them yet.

"The deflation threat is high at this point in time," Milligan said.

But words alone might not be enough, according to Milligan. While verbal intervention can mitigate fears about deflation temporarily, Draghi's statements ultimately won't have any impact without actual intervention in the currency markets, he said.

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Even worse, stimulus at this point could send the wrong message to countries that haven't taken concrete steps to mend their finances.

While Germany and Spain have made structural reforms, France and Italy still have more work to do. Launching more stimulus now would be a reward for bad behavior, Milligan said.

The euro's dip contrasts with a strengthening dollar. While Europe is talking about the possibility of its central bank aiding the economy, the Federal Reserve is continuing to wind down its stimulus as the economic picture in the United States brightens.

If the ECB decides not to act, Chandler predicts the euro will rise sharply again.

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