ECB stuck in a tight spot

With 75bps seen locked in, the focus is on other measures that can be addressed at the meeting, including how far the central bank will go.
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Uncertainty makes downside more certain

The last CPI numbers show costs continuing to rise in the Eurozone. But Monday's advance manufacturing PMIs fell further into contraction, setting up a stagflation scenario. However, about half of the inflation suffered by the Eurozone is due to high energy prices. With recent warm weather and Germany being ahead of schedule with filling its reserves, natural gas prices have fallen.

Reserves are nearly full, and over two dozen LNG tankers are loitering off the coasts of Europe, waiting to unload more energy. Germany's policy of paying any energy price has now resulted in a surge in supply, which might mean that the main driver of inflation is about to reverse. The problem is how this plays out is determined by a series of unpredictable factors: the weather, the political climate, and a war. Given that uncertainty, investors will likely stay on the sidelines, making economic growth more difficult.

What can the ECB do?

Unlike other central banks, which have been tightening for a longer time, the ECB is facing a problem of excess liquidity, fueling inflation. One of the ways to address this problem is with Quantitative Tightening; that is, starting to reduce its balance sheet. But Lagarde has said on several occasions that rates would have to reach neutral before that happens. Another option would be to adjust the refinancing operations (TLTROs), reintroducing a tiered system. That would help address the fragmentation issue while triggering repayments. This is seen as a more likely option, with less effect on the markets.

Another issue that could be discussed and used to encourage a reduction in liquidity is setting expectations around the so-called "terminal rate". That is how high the ECB will raise rates in this cycle, presumably triggering QT. So far, members have commented that it would be around 2.0%, which aligns with market expectations. That would presume a 75bps hike now and another 50bps in December. A higher terminal rate could raise expectations for tightening without enacting policy until the next meeting.

EUR/USD back to parity

With the Eurodollar back to parity, traders are looking for a breakout towards 1.01 next (R1). If the initial attempt gets rejected by the bears, the likelihood of printing the handle of a cup-and- handle pattern will increase. 0.99 (S1) seems like a solid base for its completion, being the low of August 23, as 0.97 (S2) appears far from forming a proportional handle. If prices reach there first, it will likely invalidate the C&H pattern, and the pair might fall back to the low of 0.9536 (S3).

The handle's formation is not necessary because the C&S pattern is not a precondition for an upward breakout. Either way, recapturing parity opens the door to 1.01 (R1) and 1.02 (R2). Surprisingly, the cap’s height, typically used to measure breakout targets of the C&S pattern, extends up to the top at 1.0367 (R3), registered on August 10.

Key takeaways

The Eurozone is facing stagflation due to rising costs and falling manufacturing output. However, much of the inflation is due to high energy prices, which may soon fall as Germany fills its natural gas reserves. Uncertainty surrounding the weather, political climate, and potential wars means investors will likely remain cautious as ECB has to address more than interest rates. The bank is considering ways to reduce its balance sheet and encourage repayments to address the problem of excess liquidity and inflation. One option is to adjust the refinancing operations (TLTROs), reintroducing a tiered system. Another option is to set expectations around the so-called "terminal rate". A higher terminal rate could raise expectations for tightening without enacting policy until the next meeting.