Buying the ECB Rate Cut

The European Central Bank (ECB) is widely expected to cut their lending rates at the June 5th meeting. There are a couple of really interesting precedents setting up. First of all, the ECB is expected to not only cut their discount rate but also the deposit rates paid to banks who park cash overnight at the ECB. Given the already low starting rate of .25% discount and 0% overnight, the expected cuts will cut the current discount rate in half and drive the overnight rate negative. Thus, the ECB will be charging banks to hold bank deposits. Secondly, the Euro currency market internals should be weakening ahead of the expected rate cut. After all, the rate cut should make owning Euros less attractive to the investing public's hunt for yield. We'll examine both of these situations as the former plays out on the macro landscape while the latter presents an immediate trading opportunity.

The EuroZone's post crisis economic recovery has been uneven, at best. Money poured into developed German manufacturing once the crisis lows had passed. Germany, which accounts for approximately 30% of the EuroZone's output had by far the healthiest economy of the member countries. The economic crisis simply allowed investors to buy into the choicest industries at bargain prices. Once yields spiked in the weakest countries and the all of the government bailout programs were announced and implemented, money flooded into the backstopped bonds of Italy, Spain and Greece. The hunt for yield on deposits as well as industrial return on equity has driven the Euro currency up nearly 15% over the last two years.

The effect of the Euro's appreciation against the Dollar has caused the exact problems that the ECB hoped to avoid. The ECB's goal was to drive down the value of the Euro making their exports more competitive on the global markets thus, fueling their own economic growth. The ECB's expected cuts are intended to stave off deflationary pressures as the low hanging fruit of the EuroZone crisis has already been plucked and these investments have begun to mature. Nominally, cutting the discount rate from .25% to .1% – .15% will not have much affect even though this may be phrased by the media as an, "ECB Cuts Discount Rate 50%!" headline. The impact on overnight rates turning negative may in fact have a significant impact on targeting the monetary easement the ECB still feels is required in the southern portions of the European Union by forcing medium sized and local banks to make funds available to spur economic development in this specific region within the EuroZone.

The broad goals of the ECB's actions are to stimulate local pockets of economic activity while simultaneously driving down the value of the Euro currency. I believe that the negative interest rate on the overnight money may very well do the trick but, there are other circumstances that lead me to believe that even with the rate cut, the Euro currency may not decline as expected. As I stated earlier, the Euro currency market's internals should be weakening ahead of the rate cut. After all, Euro currency owners will be receiving less compensation for owning the currency after the cut. What really got my attention was the fact that commercial traders were net buyers of 72,000 contracts over the last three weeks according to the Commodity Futures Trading Commission (CFTC) Commitment of Traders (COT) report.

This type of buying is pretty rare. I found six instances over the last ten years where commercial traders bought at least 70,000 contracts in any three-week period and the impact on the market was pretty clear. Six out of the seven cases provided a positive return in the Euro currency one month later. The largest jump was 2.8% in May of 2012. The only negative return was a loss of 1.1% in November of 2004. The average return for all seven occurrences is 1.4%. The commercial traders' actions certainly do not mesh with the ECB's intentions. The short-term implication of this situation is an ideal setup for our commercial trader signal methodology . We have strong commercial net buying and momentum. Hopefully, the initial announcement will create a sell-off that will push the Euro into a short-term oversold condition thus, allowing us to buy in at a discount and capture the coming month's expected appreciation. This could lead to quite a face-off as the world's largest traders seem to be at odds with the one of the world's largest financial institutions.

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