ECB to Prompt a Euro Rally Today Forecasts City Index's Brooks

The Euro exchange rate complex is forecast to rise as a result of today’s European Central Bank decision according to the base-case scenario posited by Kathleen Brooks, Research Director at City Index.

On Thursday we get the final ECB meeting of the year, the policy decision will be announced at 1245 GMT, with President Draghi giving his press conference at 1330 GMT.

No change in rates is expected, however, the key decision to watch out for is whether the Bank will extend its QE purchases beyond March 2017, when they are currently expected to expire.

Our view:

• We think that Draghi and co. will extend their QE bond purchases out until June 2017.
• This could disappoint some in the market, who may be looking for an extension until September 2017.
• Draghi may confirm that there is talk about how and when to taper, but no decisions have been made at this stage.

We think that the bank will err on the less dovish/ more conservative side for two reasons:

Firstly, the economy is enjoying a good run of economic data, which should ease unemployment and lift inflation. Citi’s economic surprise index for the Eurozone is at its highest level since 2013.

Secondly, the Bank’s QE programme could be doing more harm than good. Basically, there is a scarcity of bonds that meet the ECB’s strict criteria before a purchase can be made.

If the ECB continues with its bond purchases at this rate then we could see a serious disruption in Europe’s bond market, something the weaker Eurozone nations need like a punch in the eye.

Between a rock and a hard place

Although the ECB may not want to continue its QE programme, it really has no choice.

In contrast to the US, where the economy seems to be transitioning to one that relies on fiscal largesse rather than monetary largesse to unleash a new wave of growth, there is little chance of fiscal or structural reform in Europe in the coming months due to key political elections in France and Germany in May and September, respectively.

This does not mean that the ECB will sound happy about extending its bond purchases, we expect Draghi to reiterate that tapering is coming, but what he may not say is that with so many risks, particularly around the Italian banking sector, now would not be an expedient time for the ECB to reduce its monthly bond purchases.

After all, Draghi is the one who said he would do ‘whatever it takes’ to save the euro area; this pledge is relevant as much now as back in 2012.

The market impact: What to watch

Ahead of the meeting:

• German bond yields are rising.
• Italian bond yields continue to fall.
• European stocks are at their highest level since April 2016.
• The euro continues to extend its recent strong run and EURUSD is at its highest level for three weeks.

If our view is correct, and Draghi announces a 3-month extension to the ECB’s QE programme, this is likely to be perceived as less dovish than expected, which could:

• See another leg higher in EURUSD, potentially back to 1.0887 – the 50-day sma. The rally will only really get going if EURUSD manages to break above 1.0929 – the 38.2% retracement of the May – December decline. This could be a step too far, especially with the Fed meeting looming next week, and is thus key resistance.
• A rally in German bond yields, the market is likely to get excited if German 10-year yields rise to 0.5%, which could help drive the euro rally.
• A further boost to European banking stocks. The Eurostoxx banking sector has enjoyed a strong rally this month, and it is now back at March levels.

This has been led by gains for some of Europe’s biggest banks including Deutsche Bank.

There is no doubt that European banks have been lifted by the rally in US banking stocks, but negative interest rates in the Eurozone have hurt European banks’ profitability, so a less dovish Draghi could add another dimension to this rally, and we could see further gains in Europe’s largest bank stocks in the coming days.

Overall, as Italian referendum concerns have not come to pass, the ECB has more wiggle room to deliver a mild, or conservative, extension to its QE programme. While the ECB can’t pull the trigger on tapering just yet, plans are likely to be afoot.

Everyone will be watching to see how much of these plans Draghi is willing to give away later today.