ECB to pause with all eyes on next move

The market expects the ECB to hold pat after its latest hike, but there is considerable doubt about the rate outlook given the economic situation and resurgent oil prices that will likely contribute to inflation.

The Market-Moving Factors

• Markets have priced in an ECB hold, with the focus on a September hike, which is given almost 90% odds.
• The ECB has a more benign outlook for the economy than the market, which could lead to a hawkish surprise that weighs on the euro.
• Market reaction is likely to depend on emphasis on data (dovish) over inflation (hawkish), with the market reacting counterintuitively given slow growth in the Eurozone.

ECB to Pause and Assess the Situation

Economists unanimously agree that the ECB will keep rates unchanged at Thursday's meeting, with the market pricing in odds of over 90%. This means that the decision itself is likely to weaken the euro, though only slightly. What is much more likely to drive markets is commentary and outlook, as both economists and the market expect President Christine Lagarde to lay the groundwork for a hike at the next rate decision in September. The market is pricing in an almost 80% chance of a rate hike at the next meeting in September, and if the ECB's communication is more data-centred and ambiguous, it could affect the currency. The conventional wisdom is that a rate hike would support the currency and raise EURUSD by narrowing the rate gap with the Fed. However, the sluggish economy could mean traders are more worried about the growth outlook, so if the ECB leaves the market in doubt about a September hike, it could actually support the currency.

The ECB hiked rates at its last meeting, and officials have spent the past month trying to justify the move as not for "insurance" purposes. Economists noted that at the time, there hadn't been much in the way of second-round effects from higher energy prices. This gave the impression that the ECB's move was pre-emptive, intended to head off inflation pressures that might result from reduced energy supplies due to the war in the Middle East. Now that the Strait of Hormuz is once again closed, those inflation pressures might continue. A closer look at the minutes of the last meeting points to a different issue: ECB officials were cognisant of the lower growth in the first quarter even before the war was fully underway. But they attributed that to regional issues as the shared economy grew, if adjusted for Ireland, while inflation pressures were rising in the services sector. The vote to raise was unanimous, suggesting a broader hawkish shift in the ECB's thinking beyond developments in the Middle East.

Data-Centred or Anti-Inflationary

The market reaction and how EURUSD might move in the wake of the decision may hinge on how the ECB emphasises its main concerns. After the last meeting, the statement focused on data dependency and uncertainty given the ongoing geopolitical situation. At the time, the market interpreted it as more hawkish, given the high price of crude. Then Lagarde delivered a pivotal speech at the ECB Forum in Sintra, emphasising that fighting inflation was the key focus, regardless of the geopolitical situation at the time. In the current circumstances, if the ECB suggests uncertainty in the outlook, the market might interpret it as a more dovish signal. If that reduces the odds of a September hike, it could support the euro, as markets are more concerned about the growth outlook than the ECB is. On the other hand, emphasis on inflation would likely be seen as a hawkish signal and weigh on the EURUSD.

EURUSD Biased Down Ahead of ECB

Fibre is trading below its median Bollinger Band ahead of the ECB, suggesting a bearish bias. However, with 1.1400 already acting as support, a hawkish interpretation could send prices above 1.1422, followed by the upper Bollinger Band at 1.1449 and the peak at 1.1475. On the other hand, a dovish interpretation could open the door to 1.1375, and if that fails to hold, it will expose the next support at 1.1362.

Source: SpreadEx | EURUSD, 4-hour Chart