Who Will Take First Swing at Euro Crisis—Fed or ECB?

Traders are handicapping which central bank will come out swinging first — and the odds right now are not on the European Central Bank.

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So it would be a surprise if the European Central Banktakes action at its rates meeting Wednesday morning. The meeting is followed by an 8:30 a.m. ET press briefing by ECB President Mario Draghi.

Later in the day, the release of the Fed’s beige book, a roundup of economic activity region by region, at 2 p.m. ET could provide clues on the strength of the U.S. economy, and therefore on whether the Fed sees enough weakness to consider a new round of easing, either at its June meeting or later.

But more importantly, Fed watchers await the words of Fed Vice Chair Janet Yellen, who speaks in Boston at 7 p.m. Wednesday evening, and also Fed Chairman Ben Bernanke, who testifies Thursday morning before the Joint Economic Committee.

“I actually think Yellen says more than Bernanke. I think Bernanke just gives an update on the economy,” said J.P. Morgan economist Michael Feroli. Yellen is one of the more dovish voices on the Fed, so the market listened several weeks ago when she said there was a high threshold for quantitative easing.

Since then, a weaker stream of economic data and in particular, the poor May jobs report, has brought back the idea of more Fed easing. Economists have been shaving GDP expectations in the last several days, and J.P. Morgan now sees 2012 GDP at 2.1 percent, from 2.3 percent.

The Fed’s quantitative easing programs have involved purchases of Treasury securities, but another round could also include mortgages. The Fed also may just extend its “Operation Twist,” which expires at the end of the month. That program involves the sale of shorter-dated Treasurys and the purchase of a similar amount of longer-dated notes and bonds. Unlike QE, Twist does not expand the Fed's balance sheet.

“I’m not so convinced we see a large QE announced. If we do see anything, I think it’s an extension of Operation Twist and perhaps pushing back the rates guidance,” said Feroli.

RBS senior Treasury strategist John Briggs says the bond market is already pricing in an extension of Operation Twist, and he believes the Fed would extend it until the end of the year.

The Treasury market Tuesday saw some selling and rates moved higher. The 10-year yield, which sunk below 1.5 percent last week for the first time, rose to 1.56 percent.

“Yields are rising. For once, we didn’t have the steady drip of bad news that is required to keep 10-year yields below 1.5 percent,” said Briggs. “I don’t’ think anyone thinks Europe is resolved but for once we didn’t have data in the U.S. disappoint.”

The ISM nonmanufacturing survey, reported Tuesday, was slightly better than expected at 53.7, up from 53.5 in April. It is the first in a recent string of economic reports that didn’t come in below expectations, a pattern that has raised concerns the effects of the European sovereign crisis are hurting U.S. growth.

“It feels like we’ve taken the first part of the storm, and we’re sitting in the eye waiting for the winds to pick up,” said Briggs.

The Dow Tuesday snapped a four-day losing streak, ending up 26 points at 12,127, and the S&P 500 rose 7 to 1285. The euro lost ground against the dollar, ending the day at 1.2453.

Year of the Draghi

The ECB is widely expected to hold back on rate cuts or other actions until after the Greek election June 17 and the European leaders summit at the end of the month.

“There’s no reason or them to wait, but we do think they hold out until July,” said Feroli.

Alan Ruskin, G-10 currency strategist at Deutsche Bank, also expects the ECB to hold off on any move. “I wouldn’t be too carried away with expectations, given that it all revolves around events,” he said. “They’re going to be inclined to keep their power dry, and just wait on events in Greece and to some extent, events in Spain.”

Euro-zone politicians are now the ones who should act, he said. “There’s a feeling the ball is more being hoisted into the politicians’ court," Ruskin said. "They’ve got to make some decisions on things like a banking union, deposit insurance and bank recapitalizations. Those issues are best addressed at the political level.”

Ruskin said Draghi may sound more dovish when he speaks Wednesday. “He can certainly make clear they have a number of tools at their disposal, without expanding too much on it. Clearly, they have a mixture of a different things they could do. They could still cut official rates. They could still come up with another LTRO (liquidity program). They could use their strategic market program to buy bonds. They could ease collateral rules.”

But Marc Chandler, chief currency strategist at Brown Brothers Harriman says there’s a case to be made for an ECB move as early as Wednesday. “I suspect there’s a greater chance they do something tomorrow,” he said. Chandler said Draghi may prove to be more proactive than the market is expecting.

“He cut interest rates in his first two meetings, and in his second meeting, he told us about the LTRO. The market confuses Draghi and (former ECB President) Trichet,” Chandler said.

In addition to the ECB, the Bank of England holds its rate meeting Thursday and it could take further easing actions. Chandler said there is also speculation China may move on rates.

What Else to Watch

Besides Yellen, San Francisco Fed President John Williams speaks at 3:30 p.m. on the economic outlook.

In addition to central bankers, there is also productivity and costs data at 8:30 a.m. Earnings are expected from Hovnanian, Vail Resorts and Brown Forman before the open. Annie’s, Harry Winston Diamonds, Men’s Warehouse, Pall Corp and Pep Boys report after the close.

Follow Patti Domm on Twitter: @pattidomm

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