July ECB Meeting Preview

The ECB has already said it will pull the trigger on hiking rates so the focus is on what kind of mechanism it will announce to deal with uneven interest rates across the shared economy.

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Keeping everyone on their toes

Just days before the policy decision, ECB board members are publicly disagreeing about the path forward. The latest was Kazimir, tweeting yesterday that both 25bps and 50bps will be discussed. This follows Rhein on Monday arguing for a 25bps hike at this meeting and 50bps for the next. Be that as it may, the consensus among economists is that there will be only a 25bps hike, which means that the Eurozone’s interest rates will still be negative after the meeting.

What's getting a lot more attention is the so-called "anti-fragmentation" mechanism, that's meant to counteract the widening yield spread between "periphery" and "northern" countries. For example, the yield on 10-year Italian government bonds is much higher than the yield on German bunds. (A good deal of that has to do with uncertainty about how specifically it will work. There has been a lot of talk about it being "bold", "flexible" and "credible", but very little in terms of details about what that means.

The long term issue

Whatever it is, there is a distinct risk it might not satisfy the markets. The natural mechanism for dealing with high inflation is for higher bond yields. The whole point of raising rates is to increase the cost of credit and slow down the speed of money circulation. Periphery countries have higher inflation rates than central countries, so it's not a surprise they also have higher yields.

A mechanism that would "flatten" the interest rate differential would imply allowing higher inflation in the periphery, which is what is pulling up the average inflation rate. Italy's latest inflation was 8.5%, while in Germany it was 7.6%. An even bigger difference is with Spain at 10.2%. While there might be a positive response to a "bold" mechanism, the "credibility" of the mechanism could cause some doubts as economists study the impacts. That could lead to increased market volatility.

But, as of Tuesday, the ECB was still negotiating the legal framework of this unprecedented mechanism.

EUR/USD must stay above $1

EUR/USD has bounced off the multiyear low of $0.9952, to levels near $1.0270 on Wednesday morning. The rejection occurred after prices slid to the bottom of the channel connecting the $1.2556 and $1.2350 trendline, to its bottom parallel extension of $1.0340. The channel potentially means EURUSD bottomed near parity.

If the currency pair gets past $1.0350, $1.0637 is near-term resistance as the 20-week average and swing low of March ’20 meet there. Above, there lies the $1.0775 swing high of May ’22, followed by the 50-week average of $1.1133. In between, the $1.10 round level is major resistance.

Inversely, if $1.0350 is missed or rejects bulls, parity comes back in focus as its weakness could lead to fresh multiyear lows below $0.9952 but probably within the channel still.

Source: Spreadex trading platform

Key takeaways

The ECB is set to raise interest rates 0.25% on Thursday, but the market is focused more on how the “anti-fragmentation” mechanism will work. ECB has been discussing a radical new way to reduce interest rate disparity, which if successful could mitigate market volatility.