By Anirban Nag
LONDON (Reuters) - The euro languished near four-month lows on Thursday as investors wait to see how aggressive the European Central Bank will be in loosening monetary policy to tackle the threat of disinflation.
The bank is widely expected to cut interest rates by 10-15 basis points, sending the deposit rate into negative territory for the first time and injecting liquidity into the banking system. The market also thinks it will offer longer-term loans in a bid to boost lending, without launching large-scale asset purchases as the Bank of Japan has done.
Many see that as the first step towards quantitative easing by the ECB, prompting speculators and investors to build up large bets against the euro. Traders said if the ECB falls short of expectations, it could see the euro bounce.
The ECB will announce its rate decision at 1145 GMT (7.45 a.m. EDT) and President Mario Draghi will give a news conference at 1230 GMT (8.30 a.m. EDT).
The euro was steady on the day at $1.3600, not far from a four-month trough of $1.35855 plumbed on Tuesday on trading platform EBS. It has shed almost 3 percent from highs near $1.4000 after Draghi on May 8 prepared the market for possible policy action at the June review.
"Investors could cut some of their euro shorts helping euro/dollar higher toward $1.3700 if the ECB delivers but does not exceed market expectations," said Valentin Marinov, currency strategist at Citi.
"We think that there is scope for greater dovish surprises in the form of long-term refinancing operations as well as indications that QE will be on the cards soon, which could keep euro under pressure in the aftermath of the meeting."
Reflecting the nervousness over ECB action or lack thereof, overnight euro/dollar implied vols jumped to 21.85 percent from around 4.6 percent at the start of the week. The one-month implied euro/dollar volatilities - a gauge of how sharp swings are likely to be - continued to stay near four-month highs, trading at 6.95 percent on Thursday.
"Given market pricing and high expectations for ECB action, the risks of near-term disappointment are not inconsequential," Marvin Barth, strategist at Barclays wrote in a note.
Still, Morgan Stanley analysts reckon the imposition of negative rates could lead to an exodus from euro zone money markets. They expect U.S. money market funds, who have holdings of around 350 billion euros in the euro zone, to liquidate some of their holdings, putting downward pressure on the euro.
RATE DIFFERENTIALS FAVOR DOLLAR
Expectations of ECB action have helped drive German bond yields lower, giving the dollar a bigger rate advantage. U.S. two-year Treasuries now offer the biggest premium over their German counterparts in almost seven years.
With the common currency on the back foot, the dollar index held near a four-month peak set earlier in the week. It was last at 80.624.
U.S. data was mixed on Wednesday but still supported views the world's biggest economy is recovering from a weather-induced slowdown early in the year.
Institute for Supply Management data showed faster services sector growth while payrolls processor ADP data showed companies hired far fewer workers than expected in May, raising the risk of disappointing payrolls data on Friday.
The yen, meanwhile, appeared to be stabilizing after falling in the past few sessions. The dollar eased 0.2 percent to about 102.55 yen, down slightly from a one-month high of 102.80 yen set on Wednesday.
News this week that Japan's Dai-ichi Life Insurance Co has agreed to buy U.S. peer Protective Life for $5.7 billion in the largest acquisition by a Japanese insurer, also held the attention of traders.
(Additional reporting by Masayuki Kitano in SINGAPORE; Editing by Hugh Lawson)