ECB Meeting Preview - Will the hawks' squawks finally be heard?

Heading into this ECB meeting, traders are trying to figure out if last week’s punchy inflation number (3% vs 2.7% YoY) is enough to finally galvanize the ECB into slowing down its pace of asset purchases via PEPP. In my opinion, that’s all that really matters for this meeting. The inflation numbers and looser financing conditions (compared to the middle of this year) will be why the hawks on the governing council call for a taper. I’ve been keeping a close eye on the 10-year Bund yield and BTP-Bund spread, which have both ticked up higher of late (indicative of the market pricing in less stimulus prior to Thursday’s meeting?).

The euro had begun to price in hawkish expectations and this created downside risks on a dovish surprises (i.e. no taper). Although the euro has pulled back a bit now, I still think if Madame Lagarde chooses not to alter the pace of PEPP and leave it as is - it could put some further pressure on the single currency, ceteris paribus. If we do get a taper then there might be some juice left to squeeze out of the euro, however, dollar strength could be a headwind. I think it’s too early to hear more intricate details about further stimulus (APP) in a transition to a post-PEPP world, we will likely hear about that at the end of the year.

I’d expect any taper to be accompanied by a dovish twist in typical ECB fashion as we saw with the RBA on Tuesday. This could be achieved by using dovish language such as emphasizing the flexibility of PEPP and that the pace of asset purchases could easily be increased again if financial conditions warranted such a move, as well as policy settings remaining accommodative even after PEPP concludes. With circa €500bln left in the PEPP envelope, a taper of €20bln/month from €80bln/month currently to €60bln/month would mean the programme would run beyond March 2022. As it stands the programme is expected to be wound up in March 2022, which would mean the envelope is not exhausted (if taper occurs) - now that could be interpreted quite hawkishly by some if communication is not solid by Lagarde. A fair compromise for the hawks and doves would probably be to taper and extend PEPP purchases past March 2022, making sure the full envelope is utilised. An expansion of the envelope would be a non-starter for the hawks unless there was a serious external shock and setback economically.

We’ll also be receiving updated economic projections from the ECB tomorrow. It’s a consensus view that growth and inflation will be upgraded. The economy outperformed the June GDP forecasts for Q2 of 1.4%, with the final estimate coming in at 2.2% on Tuesday. Coupled with easier financial conditions, an increase in vaccinations, improved crude prices, supply chain bottlenecks and a weaker euro throughout most of Q3 this should result in better GDP growth and inflation forecasts. The inflation profile will follow the playbook of steeper across 2021 and 2022 with a decline into 2023 - indicating the transitory views of the ECB. To change that view we’d have to see robust and persistent wage growth. 2023’s number will be key to inform us how far away inflation is from their target of 2%. The ECB faces an uphill battle to lift inflation to its new 2% target on a durable basis, especially if history is anything to go by. This rases the issue of credibility for the ECB in terms of achieving their new target.

In the ECB’s new forward guidance, we know that interest rates aren’t going anywhere until inflation reaches two percent well ahead of the end of the ECB’s projection horizon and must remain at that level sustainably. Money markets are pricing for lift-off by September 2024. There is a risk of this date being brought forward on a hawkish taper (not softened by dovish rhetoric) as well as a chunky inflation revision upwards for 2023. This could see a bid in euro crosses.

EURUSD:

The euro had been gaining against the dollar, despite the recent pullback price is still above its 50-day SMA and upper trend line of its descending channel. But now it looks like the 1.19 resistance is proving too much with a potential double top in the making. The RSI looks to have peaked and is rolling over back towards the 52 level. Upside targets remain 1.19 resistance and above there 1.20 around the 200-day SMA would be next. On the downside 1.18 (50-day SMA) and 1.175 support would be important levels.

EURGBP:

EURGBP has been treading water over the last 2 weeks, bumbling about the 0.8550 support and 0.86 resistance. For those with a bearish bias, I'd like to see price candles back below the 50-day SMA. The 21-day EMA seems to be working as a form of dynamic support for price dips. The RSI moved towards 61 resistance (marked previous price rallies) and rolled over but is now seeing a slight bounce back to this level. Targets on price moves upwards are around 0.86 and 0.865. On the downside, 0.855 around the 50-day SMA and then 0.85 lower from there.