5 things you need to know ahead of the key ECB meeting

Summary:

ECB to decide on monetary policy on Thursday, this is the most anticipated ECB meeting so far this year
Bank could provide hints on tapering of bond purchases
Inflation forecast could be trimmed because of strong euro
EURUSD in a clear upward sequence, key levels are 1.1660 and 1.2070
Euro could look stretched against some metrics

The ECB meeting on Thursday could be the most important market event in September. The European economy has seen a major recovery so far this year and it is time for the ECB to respond. But isn’t the euro exchange rate already too high? In this analysis we present the 5 things you need to know to be prepared for this trading opportunity.

1. ECB to decide on rates – why is this meeting important?

The economy of the EMU grew above 2% in the second quarter with no country registering economic contraction. Inflation, while still below the ECB target, has picked up. Business and consumer surveys remain strong and point to continued expansion. All this convinced markets that the ECB will start shutting down its program of bond purchases starting next year. If so, the Bank could start preparing investors and there are expectations that first hints will be presented at the September meeting. Therefore, it could be decisive for the euro.

The ECB meeting on Thursday could be the most important market event in September. Source: pixabay

2. What the ECB could do and what do investors expect?

Let us recall that the ECB maintains its deposit rate (the most important rate in Europe over the past few years) at -0.4% and continues to buy government bonds worth some 60 billion euros each month. Any change in rates is out of the question, the ECB also pledged to stick with the current level of asset purchases until the end of the year. So the big question mark is if the ECB makes any announcements regarding the policy next year. Because the economy improves markets expect the ECB to start terminating the bond purchases, perhaps in a phase-out fashion (buying less and less bonds each month in 2018). Investors want to know the details but are unlikely to get them this time. They will be mincing words. If Draghi says that “internal committee has been tasked to assess QE tapering operations” investors could interpret it as a direct step towards changes that in turn could be announced at the next meeting. If there is nothing on this matter, euro bulls could be disappointed. Investors will also watch for comments on the euro itself. The ECB must not like the EURUSD rally but the question is if Draghi chooses to talk it down. He dismissed such questions in the past saying that “exchange rate is not a policy target” and this could actually be a chance for the euro. Keep in mind that a decision will be announced at 12:45pm BST (13:45 CET) but the conference will begin at 1:30pm BST (14:30 CET) and this is when the strongest reaction is expected.

3. Watch out for inflation forecasts!

Four times a year the ECB prepares new macroeconomic projections. Because of the strong euro the ECB could slash its growth and inflation forecasts, especially for 2019. A decline of 0.1-0.2 vs forecasts in June has been penciled in, anything above that could be a warning sign that the euro is too strong for the ECB.

4. Key levels for EURUSD

EURUSD remains in a clear upward trend with few signs of weakness. Source: xStation5

EURUSD has been in a clear upward sequence with higher lows and higher highs flowing in a very systematic fashion. The impulse waves in this bull markets had at least 400 pips – a range that was met when the pair touched 1.2070, this is the key resistance for now. A previous higher low of 1.1660 is the crucial support – the EURUSD is in uptrend for as long as this support holds.

5. Is euro valuation stretched?

Looking at real exchange rate the euro could be just a notch above its historical average. However the ECB could be concerned with the pace of its appreciation. Indeed when we look at the bond market we can see that EURUSD climbed higher that a 10-yield spread between US and German bonds would suggest.

EURUSD climbed relatively more that the 10-year bond spread. Source: Bloomberg, XTB Research

On top of this keep in mind that speculative positioning in the euro is close to multiyear highs. However these are medium-term metrics and could not have direct implications for reaction of the euro to the ECB meeting on Thursday.