EUR/USD above parity ahead of ECB

A 75-basis point rate hike appears to be a foregone conclusion

FOREX 4

The EUR/USD and European stocks will be in sharp focus today as the European Central Bank decides on monetary policy. Overall, we don’t think that its decision will have much of a positive impact on the EUR/USD or European stock markets.

The European Central Bank will once again have to turn a blind eye on yet more recessionary signals in the Eurozone, China and elsewhere as it battles to bring inflation back under control and stop inflation expectations from rising materially. A 75-basis point rate hike appears to be a foregone conclusion, which means the reaction of the euro and European stocks will depend on more than just the rate decision itself.

While the recent weakening of energy prices and mild weather across the Eurozone is a welcome sign, this has already helped to soothe investor nerves a little with stocks and euro both bouncing off their lows. However, the economic situation remains dire and the latest macro data continue to paint a grim picture, with the outlook remaining highly uncertain. Against this backdrop, it is highly unlikely in our view that the ECB will want to provide too hawkish a surprise at this meeting.

 

What to expect from ECB rate decision?

 

After finally lifting the main refinancing rate from zero to 0.5% in July, the ECB’s next move was a 75-basis point hike in September. The market is pricing in another 75-basis point rate hike at this week’s meeting, which would lift interest rates from 1.25% to 2.00%, the highest since February 2009. We don’t anticipate there to be any surprises on the rate decision itself. The ECB is also unlikely to talk up Quantitative Tightening (QT) given the increased recession worries in the Eurozone.

How will EUR/USD and European stocks react to ECB decision?

 

With a 75-basis point hike being fully priced in, the euro will need the ECB to provide a hawkish surprise to send the EUR/USD pair significantly higher. But this is unlikely given an increasingly weakening Eurozone economy. Meanwhile with the Fed maintaining its hawkish rhetoric heading into the FOMC meeting next week, any weakness in the dollar is also likely to be temporary. Thus, any ECB-related gains for the EUR/USD are likely to be short-lived.  Similarly, the major indices are also unlikely to find significant support from the ECB, as investors’ focus remains fixated on stagflation signs and global central bank tightening.

 

Can the ECB surprise the markets?

 

As mentioned, a 75bp hike is almost a done deal and talks of QT are also premature given the increased macro risks facing the Eurozone economy.

One of the ways the ECB could surprise the market is through jawboning the EUR/USD higher. Given that the weakening EUR/USD exchange rate means more and more inflation is being imported to the Eurozone, the central bank would prefer if the EUR/USD was much higher right now. However, without action, verbal intervention is unlikely to work on a sustainable basis.

The ECB is also unlikely to start actively selling bonds it holds, to start the process of QT. But it clearly wants to mop up liquidity in the coming months. As ECB President Christine Lagarde has mentioned previously, the central bank will look to end the reinvestments under the Asset Purchase Programme (APP) when interest rates are neutral. As things stand, this is still months away, but if the ECB signals it is going to stop reinvestments and APP, then this could be seen as a hawkish surprise.

The other question is when will the rate hikes will stop – i.e., what will be the terminal rate? With rates likely to rise to 2% at this meeting, the ECB could provide some hints as to how high interest rates could go up from here onwards. Previously, the neutral interest rate was seen to be around 1 to 2 per cent, but this band is likely to have risen slightly in light of the inflation shock. The ECB will not want to move too high above the neutral rate as the economy is very weak. Thus, the pace of future rate hikes could slow, starting in December. Perhaps 50bps in December and a ‘standard’ 25 basis hike in their first meeting in 2023 could be the possible path for rate hikes.

If that’s the case, this will hardly surprise anyone, and may result in a weakening of the EUR/USD. In contrast, if the ECB signals further aggressive hikes for December and beyond, then this may provide moderate further upside for the EUR/USD.

EUR/USD

Indeed, it will not be the first time where any short-term strength in the euro as a result of a hawkish ECB surprise faded. Since the start of the year, we have consistently seen the EUR/USD go down after any brief period of strength. If the EUR/USD fails to hold its breakout above parity again, then this could pave the way for a move down to 0.9875 support, potentially ahead of more losses in the days ahead.

The breakout from the bearish channel will appease the bulls but do watch out for the EUR/USD to potentially go back inside the channel and thus re-establish its bearish trend. A move below 0.9875 support is what could put the bulls in a spot of bother.

 

Stocks set to suffer further

 

The markets are always calling the shots and that won’t change on Thursday. The fact that the Eurozone economy is on its knees despite the recent drop in some energy prices tells you all you need to know. Furthermore, the other side of the EUR/USD’s equation, i.e., the dollar, continues to provide counterbalance to any short-term up lift the EUR receives. The remains very hawkish and this will keep the dollar supported on the dips. The Eurozone data released so far this week have been quite poor, especially the latest PMI data, underscoring the challenges the ECB faces at a time when inflation remains very high. With the global economy slowing, and central banks having to tighten their belts further, it is difficult to see how stock markets would thrive in this sort of environment, after this year’s mostly weakening asset prices.

 

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