The ECB is widely expected to keep rates unchanged at the end of its rate decision meeting on Thursday, with the main focus being on the statement and President Christine Lagarde’s comments. The market is expecting that she will lay the groundwork for a hike at the next meeting. But there is considerable uncertainty about the outlook, which could move the EURUSD substantially.
The Euro is also likely to react counterintuitively. Normally, higher interest rates mean the currency gets stronger. But higher rates intended to fight inflation have a side effect of weighing on economic growth. After the Eurozone economy contracted in the first quarter, this could be a bigger concern for markets. If they expect rate hikes to keep the Eurozone economy in the red, a more hawkish ECB could actually weaken the Euro.
What Are the Odds of a Hike?
Economists all agree that the ECB will hold pat at the upcoming meeting. The market is pricing in over 90% odds, meaning there is little room for a reaction if the ECB delivers as expected. The focus will be on the next meeting, which is scheduled for September. For that meeting, the odds are more than 80% of a rate hike. Typically, central banks don’t like to shock markets, so markets expect some signal of a rate hike.
If that doesn’t happen, it could be a dovish surprise for the market, which could end up actually supporting the Euro. The market reaction will depend on whether the statement and Lagarde place emphasis on data dependence or on fighting inflation. And here is one aspect in which the market outlook differs from the ECB’s.
The ECB is Not Worried About the Economy
The minutes of the last meeting, when the ECB hiked by 25bps, showed something interesting. Rate setters acknowledged that the Eurozone economy shrank at the start of the year, but attributed it to regional issues. When excluding Ireland from the data, the Eurozone had positive growth. Participants also noted concern that the war in the Middle East would drag on the shared economy, but said that they were more worried about inflationary implications.
The ECB has spent the last month trying to justify its rate hike, one of the first of major central banks. Economists generally concur that there haven’t been notable second-round effects from higher energy prices yet. That means that higher fuel costs have not significantly affected the broader economy. However, the minutes showed that the ECB was more concerned with accelerating services prices, and actually believes that the energy impact won’t be as significant. In other words, the ECB sees itself at the start of a tightening cycle separate from (though pressured by) the situation in the Middle East.
How Will the Market React to the ECB Rate Decision
After the last meeting, Lagarde emphasised data dependency and market uncertainty, which at the time the market interpreted as being hawkish. However, since then, Lagarde has spoken at the ECB Forum in Sintra, laying out a “return to fundamentals” outlook focused on fighting inflation.
If Lagarde repeats her language from last time around, highlighting uncertainty and data dependency, the market might take it as a dovish signal, since the data doesn’t support aggressive rate hiking. This could shore up the Euro. An emphasis on inflation and confidence in economic growth could, counterintuitively, weaken the Euro.
