Market Analysis

ECB: Walking A Tightrope

An arguably already priced Fed rate hike should occur on Wednesday leaving the European Central Bank to be a centre of attention on Thursday. With the US dollar more on the front foot versus the euro than in recent weeks, with EURUSD someway below its recent highs above 1.1900, the ECB might be relatively pleased with itself. After all, while its own monetary policy setting remain ultra-accommodative in contrast to the Fed’s, and while on balance euro zone economic data has been on the positive side, the euro hasn’t run away on the topside. That means euro zone exporters who sell outside the currency bloc don’t have too many reasons to complain. It also means that euro strength isn’t overly exercising a disinflationary influence on imported inflation. But that also means the ECB will continue to have to walk a tightrope. If the ECB alludes to the possibility of a faster-than-currently-expected withdrawal of monetary accommodation, it could trigger an upsurge in demand for the euro.

At the same time, if markets perceive that the quality of euro zone economic data is suggestive of the fact that the ECB is behind the curve as regards tightening monetary policy, the market may still decide the euro is materially undervalued. One thing traders may wish to look out for is whether ECB staff inflation forecasts for the next few years are tweaked higher. Those ECB staff “forecasts from September for inflation in 2017, 2018, and 2019 were set at 1.5 per cent, 1.2 per cent, and 1.5 per cent respectively,” Japan’s MUFG noted on Tuesday. The Japanese firm also wrote that “the ECB is also expected to reveal the staffs’ forecast for inflation in 2020 for the first time” and feels that “the closer the 2020 forecast is to [the ECB’s] inflation target of near but lower than 2.0 per cent, the stronger signal it will send to market participants that QE is on course to end next year, and then to be followed by rate hikes in 2019.” ECB Mario Draghi will likely be walking a tightrope at Thursday’s press conference. Traders may find though that the devil will be in the detail.

Written by Neal Kimberley, External Currency Analyst.