ECB Looms Large for 'Expensive' Euro Exchange Rate

- ECB is main calendar risk for EUR today
- Question of EUR strength to be of interest
- Markets bearish heading into event
- But could see a "buy the fact" response

ECB Lagarde

Above: File image of ECB President Lagarde. Image Copyrights: Angela Morant/ European Central Bank

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The Euro has turned higher over the course of the past 24 hours as broader Dollar selling eases amidst an improvement in global investor appetite, however the resolve of Euro bulls will tested by the European Central Bank's September policy decision where the currency's recent appreciation will be scrutinised.

The ECB will release their policy statement at 12:45 BST, while a press conference will be conducted 45 minutes later and it is expected ECB President Lagarde will be asked about the Euro exchange rate's recent appreciation and whether it is welcomed.

The Euro rallied to its highest valuation against the Dollar since May 2018 on September 01 at 1.2011, and while it has retreated in the past few days it remains elevated and is expected by economist to present headwinds to the Eurozone's economic recovery.

ECB board member and Chief Economist Philip Lane said on September 01 - the day the Euro peaked against the Dollar - that "the euro-dollar rate does matter", a signal to the market that the central bank is in fact watching. The Euro promptly retreated from its highs on the comments, although we do know that it was also around this time that the Dollar found a bid on rising stock market jitters.

"Last week’s remarks from Lane that the value of the currency matters suggests that the issue of euro strength will likely be on the ECB’s agenda at this month’s meeting. There is a chance that this could be followed by some form of verbal intervention during President Lagarde’s press conference intended to curtail the currency’s recent rally," says Matthew Ryan, Senior Market Analyst at Ebury.

"Markets await clarification on just how concerned the ECB is with EUR strength. Directional risks are large & binary. The ECB needs to walk a narrow path to avoid a messy adjustment as EURUSD is hovering near key support levels. A push below 1.1696 could see an acceleration lower amid positioning and valuation risks. A lack of clear concern would target recent highs," says Ned Rumpeltin, European Head of FX Strategy at TD Securities.

A rising Euro lowers the competitiveness of European exporters on the international market and ultimately creates a deflationary effect on prices, which makes the ECB's job of pushing inflation back towards 2.0% all the more difficult.

However, what the ECB can do to create a weaker Euro, other than 'jawboning' remains up for debate with economists noting that it cannot be seen to be actively weakening the currency. "Beyond verbal interventions, the ECB has limited options to weaken EUR," says Athanasios Vamvakidis, FX Strategist at Bank of America Merrill Lynch.

ING expectations ECB

It is however expected that the Bank can be more aggressive in its quantitative easing policy and hope that the Euro weakens as a side effect, for this reason markets will respond to how aggressive or sanguine Lagarde and her team are on changes to existing quantitative easing programmes.

"To keep a lid on the appreciated euro, the ECB may also use some traditional verbal intervention, expressing some concern about the disinflationary impact of a stronger exchange rate. While the euro has strengthened considerably over the recent months, its pass-through to inflation is unlikely to be big enough for the ECB to change its policy stance this week. More likely, the ECB will add stimulus at its December meeting upon presenting its first 2023 forecast for inflation well below its 2% target," says Florian Hense, Economist at Berenberg Bank.

Ahead of the event, the Euro-to-Dollar exchange rate is quoted at 1.1832, up from the previous day's low at 1.1750 while the Euro-to-Pound exchange rate is at 0.9081, down from the previous day's high at 0.9130.

Analyst Viraj Patel at Arkera says the market appears to be expecting a dovish outcome to today's meeting (which would on paper drive the Euro lower).

"A dovish ECB tilt at tomorrow's meeting is almost certainly the baseline case for markets going into the event," says Patel, "some signals that a further expansion of the PEPP programme is likely later this year."

The PEPP (Pandemic Emergency Purchase Programme) is a quantitative easing programme that sees the ECB buy up Eurozone government bonds in order to keep borrowing low across the region and thereby stimulate economic activity.

On 4 June 2020 the ECB increased the €750BN envelope for the PEPP by €600BN to a total of €1,350BN.

EURUSD forecasts

"We do not expect ECB policy action this week, but guidance is that the ECB has its finger on the trigger for more PEPP. Communication will not be easy, but EUR appreciation, record low core inflation and Fed policy should make for very dovish tones," says Ruben Segura-Cayuela, Economist at Bank of America.

Patel says there is also a good chance we see the ECB emphasise that policy rates will remain low for a very long time.

"Talk is cheap and any surprise stimulus (unlikely despite the stronger macro case) would be the most effective way to move the EUR lower," adds Patel. However, he cautions more quantitative easing is not unanimously popular within the Governing Council — so it may be a tough sell for the more dovish ECB policy members.

"We think EUR/USD’s bearish bias going into the meeting means that there’s a good chance we see a “buy the rumour, sell the fact (or disappointment)” reaction — and EUR/USD could see a repeat of the ~0.50% moves higher observed after the Apr/Jun ECB meetings, especially if the ECB does not deliver any meaningful stimulus signals," adds Patel.

Most economists and strategists are in agreement that the ECB might opt to avoid any direct mention of the Euro's strength in its set statement, but Lagarde will likely be confronted by the issue during the press conference due at 13:30 BST.

"Any comments from Lagarde regarding the recent strength of the euro, or increased fears regarding a second wave of virus infection, would also trigger investors to ditch the common currency, in our view," says Matthew Ryan, Senior Market Analyst at Ebury. "We expect the ECB’s communications to take on a more dovish tilt on Thursday, particularly following last week’s dismal inflation data."

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