The time has come for the European Central Bank to take the first steps in normalizing policy. The central bank will hold a meeting next week, and market players expect at least clear signals from it to tighten policy at the next meetings, and at most a rate hike already at the June meeting. How will the ECB behave and what to expect from the euro?
The ECB has recently begun to prepare the markets for an increase in interest rates. This week, Chief Economist Philip Lane confirmed this possibility. Although these expectations may have a mixed picture, which means that the euro against the dollar will not receive the support that traders are currently counting on (the rate will rise to $1.10).
The Board of Governors plunged headlong into the debate. Financiers are trying to determine by what amount the negative rate should be raised after the expected completion of the remaining ECB quantitative easing program next week. It can be 0.25% or still 0.50%. It is difficult to guess how big this step will be.
Financial markets are pricing in a rate hike at the July meeting. Further, these expectations will only increase after the meeting next week. At the moment, an aggressive increase of 180 bps is taken into account until the end of 2023, which is about the same as at the Federal Reserve, but it is difficult to imagine how the ECB will be able to go toe-to-toe with the US central bank.
The ECB is likely to fail to meet such inflated expectations, as the region is facing great financial difficulties, and the embargo on Russian oil is gradually tightening.
However, the very fact of tightening policy and public discussions on this topic by the ECB have already helped the euro to rise from its knees. The EUR/USD pair has rebounded from near five-year lows in recent weeks. Whether the quote will be able to see higher marks will depend on how much the ECB justifies the hopes of the markets.
By the time the central bank decides to raise rates, the expectations of market players may become so excessive that it will put the ECB at a disadvantage. In other words, the central bank will disappoint the markets by raising rates by a much smaller amount than is included in the prices.
Such disappointment is not the only risk the euro may face. The focus is also on oil prices and their upward trend. They can increase whenever the euro rises or the dollar falls, which increases production costs for companies and can significantly accelerate inflation worldwide.
This not only exacerbates the deterioration of the eurozone's trade balance, which has moved from a significant surplus to a deficit in recent quarters, but also raises prices in the United States. The Fed, as we know, is struggling to resist this pressure.
Some strategists have suggested that the inflationary surge will soon become something of a red rag for the US central bank.
"The Fed should take rates seriously in order to cope with the growth of commodities and the ongoing geopolitical shift from using the dollar to barter trading at dollar prices," Rabobank comments on the situation.
Meanwhile, the April jump in inflation in the eurozone increases the chances of an ECB rate hike by 50 bps until the end. Judging by ECB President Christine Lagarde's comments, the central bank is ready to increase by 25 bps in July and again in September by a similar amount. However, in order to provide the euro with an additional impetus to growth, something more is needed, for example, a signal to raise rates from July to December.
"The euro has not been able to extract additional benefits, since the market has already included in the prices a 25 bps ECB rate increase in July and September. In order for the euro to find additional support, there should be more signs that the central bank will raise rates faster and that it may even consider steps by 50 bps," Commerzbank economists believe.
Aggressive promotion: as much as possible
Deutsche Bank became the first major investment bank to officially announce a forecast of a 50bp ECB rate hike this year. According to the bank's economists, the central bank can implement at least one rate increase by 50 bps. Most likely, it will be September, but there is a risk that a tough step will happen in July. Such a result will surprise and potentially strengthen the euro rally.
Deutsche Bank also believes that the ECB will underestimate inflation in its speech at the June meeting during the announcement of new macro forecasts. At the same time, it is inflation that requires a greater rate increase at the beginning of the policy tightening cycle.
BMO Capital strategists are rather cautious about the potential rally of the euro. They read here that the euro should benefit from a permanent exit from the policy of negative rates, but there are nuances, namely a number of reasons.
The eurozone economy is experiencing a current account deficit in the current conditions of a sharp rise in commodity prices. This region is a net importer of energy carriers. That's one of the headwinds for strengthening the euro.
Concerns may also arise as the yields on debt obligations of various countries of the bloc begin to diverge. For example, the yield of Italian government bonds compared to German ones is growing much faster, which is a sign of potential stress.
Investors are well aware that impulsiveness and haste are not at all in the style of the ECB, which is likely to choose a gradual tightening of policy. This will be a key factor in market sentiment. In this regard, we need to remain cautious about a stronger appreciation of the euro against the dollar and other world currencies.
At the end of this week, the bullish momentum of the euro came under pressure. The US published optimistic data on the labor market, which triggered a rebound in the dollar.
The potential for long positions remains limited, but the bullish trend may gain momentum if the EUR/USD pair surpasses the 1.0855 mark. Sustained growth above may mean a rally to the critical figure of 1.1000.
