Five scenarios for the ECB and EUR/USD

July 25, 2019 Off By admin-445
  • Worsening inflation expectations and bleaker growth forecasts await the ECB.
  • The bank is set to loosen policy – but the timing and nature are unknown.
  • High uncertainty is set to trigger volatility in EUR/USD.

Markets have been losing faith in the European Central Bank’s ability to reach its 2% inflation target amid global headwinds – and the bank is unwilling to let this pass. President  – which ends his tenure in November – has already signaled upcoming monetary stimulus in Sintra, Portugal, back in June. Moreover, the recent  meeting minutes have also conveyed the same message.

How we have reached this point

The difference between nominal and inflation-adjusted bonds, known as the 5y/5y swap, has deteriorated from close to 2% to around 1.3%. This gauge has been highlighted by Draghi several times.

Why are inflation expectations falling? Headline euro-zone inflation has been falling from around 2% to 1.3% as of June. While the move may be related to , core prices have been stuck as well – 1.1% in the latest read.

Prospects for lower inflation also stem from weak growth, which has barely picked up to 0.4% quarter over quarter in the first quarter of 2019 after slower growth in the second half of 2019.

More importantly, prospects for future growth have fallen. Markit’s forward-looking Purchasing Managers’ Index (PMI) for Germany’s manufacturing sector – considered Europe’s locomotive – has extended its slump. July’s preliminary read of 43.1 points reflected a significant recession in this sector.

Why has growth dropped? The list of culprits is long. The ongoing US-Sino trade war, Germany’s reluctance to loosen its tight fiscal policy, political tensions, , and other factors all cloud the skies.

Moreover, the ECB is set to act alongside other central banks’ stimulus policies. The Federal Reserve is set to slash rates next week – for the first time since the crisis – and other banks have either abandoned their intentions to raise rates or reduced them altogether. Refraining from action means allowing the euro to appreciate – further pushing inflation lower and weighing on exports.

Market positioning

The common currency has already lost ground amid the prospects of a rate cut or even a resumption of the bond-buying scheme. And it may have gone too far.  is trading closer to the 2019 low of 1.1107 and has struggled to rise against the pound – which has been falling to the lowest in two years.

Analysts are split on their assessment of the Frankfurt-based institution’s upcoming decision. Some expect Draghi to signal the ECB will take steps in September – when new macro-economic projections are due – while others  imminent action.

And what action will the ECB take? Some foresee a reduction of 10 basis points to the already negative -0.40 deposit rate while others see a slash of 20 basis points. Negative rates curb commercial banks’ profitability, and the ECB may decide to exempt some banks from the “punitive” rates – a process called tiering.

Also, the bank has ended its broad Quantitative Easing program at the end of 2018, and some expect it to renew the program. The chances of immediate action are low. If the ECB opts for fresh money printing, it may loosen its self-imposed limits on this bond-buying scheme to create a more significant impact.

So what will Draghi do and how will EUR/USD react? Here are five scenarios:

1) No cut – EUR/USD up

If the Governing Council waits until the end of the summer for its new forecasts, it may settle for pre-announcing stimulus. Draghi may say that the ECB will cut rates and consider other steps.

Even if is tone is gloomy,  EUR/USD may rise as markets are already pricing in a significant chance of an imminent cut. The probability is medium.

2) Cut + tiering – EUR/USD eventually higher

Given the recent weak PMIs and the upcoming Fed cut next week, the bank may act now. However, to appease the hawks within the GC – notably German and other northern European members – the ECB may offer a tiering model to exempt some banks.

In this scenario, EUR/USD may chop around initially and perhaps edge up. Such a middle-ground solution may only be temporarily sufficient to hold down the euro but may still be disappointing. The probability is high.

3) Outright Cut – EUR/USD grinding lower

Recent data and ECB messages suggest there is an urgency to act already now before new forecasts are due. Draghi may announce a rate cut and say that the bank is ready to lower  even further.

This option is only partially priced in, and EUR/USD may fall in response. However, with recent low volatility and the Fed decision coming next week, EUR/USD may shy away from the 2019 low of 1.1107 – even if it is close. The probability is medium.

A shock cut of 20 basis points may have a more significant effect, but the chances are low.

4) Cut + open door to QE – EUR/USD falling

If Draghi and his dovish colleagues convince the hawks about the urgency to act, the ECB may convey a clear message that a new bond-buying scheme is under consideration if the outlook does not improve.

In this scenario, EUR/USD may fall and also lose the 2019 low. Nevertheless, the upcoming Fed announcement may prevent it from plunging outright. The probability is low.

5) Cut + QE announcement – EUR/USD plunging

Draghi is credited with saving the euro in the summer of 2012 by vowing  “to do whatever it takes” to preserve the euro. However, this may not be his legacy if deflation takes over soon after he retires and if the euro-zone enters another recession. He may make a brave push – amid fierce opposition – to use all the known ammunition and announce both a rate cut and QE.

The probability of such a bold move is very low, but Draghi has shocked markets in the past. In this scenario, EUR/USD may crash below 1.10 regardless of expectations toward the  decision.

Conclusion

The ECB is set to announce fresh stimulus amid falling inflation expectations and weak growth prospects. Markets are unsure about the timing of the new stimulus and the nature of it – allowing for significant price action.

Stay tuned for a live coverage of the all-important event.

Source: www.forexcrunch.com