ECB Preview: Are Tapering Expectations Overcooked? EUR Strength Presents Risks

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Economy & ECB Fuel EUR Rally

EUR has been soaring higher over recent months as consistently strong data out of the eurozone, and a more constructive tone from the ECB have encouraged the market view that the ECB will be winding down its QE program sooner rather than later. At their summer meeting, the ECB said that decisions on QE would be made in the Autumn, leading most to anticipate an announcement at the September meeting. Consequently, COT data has displayed a significant build in long positioning which reflects the shift in tone and the sizeable rally in EUR.

The market has had a tricky few years in terms of gauging ECB action and has been caught offside quite a few times. The ECB similarly have been left red faced on a few occasions when the market has punished the central bank for misleading signals. Is it possible that once again, investor expectations have run too hot ahead of an ECB meeting?

ECB Has Warned Against EUR Strength

The ECB has recently cautioned against the strength of the Euro noting is subduing impact on inflation with ECB chief Draghi voicing his concerns at the bank’s last meeting. Furthermore, Reuters recently reported ECB officials cautioning that QE tapering may be delayed in response to EUR strength. The shift in tone over recent weeks highlights the risk that the ECB will maintain current policy at the September meeting and instead wait until October to announce further tapering. While it can be argued that EUR strength is a function of the stronger economy attracting capital, rather than speculation of a shift in ECB policy, the bank will likely want to guard against any further appreciation at this point.

However, this meeting will still be important as the ECB will likely to use it to further talk down EUR and guard against strength which is delaying them from tapering. The wording will be important here as the ECB will need to be careful not to explicitly say that they will be announcing tapering in October, otherwise they will likely still suffer an FX overshoot similar to recent months.  This time around it is likely to be more of a hint than outright forward guidance.

EUR Strength Weighing on Core Inflation

The FX overshoot is the key issue. The ECB have noted recently that while headline inflation has been steadily improving, underlying inflation remains weighted down and continued EUR strength will exacerbate this situation. With this in mind, it is likely that the ECB will revise its inflation forecasts down at this meeting, though the revision will likely only be minor and still maintain an upward trend given that EUR strength at this time isn’t an exogenous shock but partly due to strong growth and a sharp decline in unemployment, beyond ECB expectations. Furthermore, a large percentage of imports is now invoiced in Euros meaning that imports are now more sensitive to currency fluctuations.

Since Draghi’s comments at the Sintra panel in June, which first provoked the EUR rally in anticipation of a tapering announcement and a hawkish shift in rates pricing, the market implied path of ECB policy adjustment has now taken a dovish turn. In early July, the market was pricing 15bp worth of rate hikes before September 2018 which has now fallen to a 50% chance of a 15bp rate hike by December 2018 with the first hike not priced in until May 2019. This repricing when viewed against the backdrop of the current rally in EUR suggests that there is plenty of scope for a correction lower before the next leg higher.

Technical Perspective

After breaking out above the 2016 high, EURUSD found resistance on a test of the broken 2012 low with price currently stalled between the two levels. There is plenty of strong technical resistance ahead with the long term bearish trend line from 2008 sitting around 1.22/23 and the 50% retracement from 2014 highs there also.

The sharpness in the rally from December lows suggests that some retracement lower is likely and today’s meeting could be the catalyst. The rally itself has now matched the proportions of the last two significant rallies in EURUSD from the 2010 lows and the 2012 lows at which point price retraced in both cases. If price does move lower from here, the first key support will be a retest of the broken 2016 high around 1.17.

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