The recent weak economic figures from the euro area made EUR/USD test 1.0925, the lowest level since May 2017, on the expectations that the ECB will ease policy this month. Let’s analyze: how likely this scenario actually is?
There were a lot of disappointing economic releases in Europe during recent weeks. Although domestic demand is fine because of the healthy labor market, European manufacturers and exporters are badly hurt by the US-China trade war. German business confidence fell to the 7-year low in August, while the GDP of the region’s leading economy shrank by 0.1% q/q in Q2. The main risks for the region come from the outside: it’s the global economic slowdown and the hard Brexit.
Inflation expectations in the eurozone have been falling since the start of the year. The decline accelerated in the second quarter. Last month, consumer inflation remained stuck at the 1% rate, well below the ECB goal of just under 2%. The core measure, which excludes more volatile elements such as energy, food, and tobacco, was even lower, at 0.9%. The negative trend in inflation, which used to be about 2 times higher a year ago, will worry the European Central Bank a lot. That’s why market players wait for the regulator to announce the new round of monetary stimulus.
What options does the ECB have?
In June, the ECB President Mario Draghi has said that the central bank would ease policy again if inflation fails to accelerate. He also mentioned that the Governing Council had discussed such steps as fresh bond purchases, rate cuts and changes to the ECB’s policy guidance. Christine Lagarde, who will succeed Draghi as the head of the ECB on November 1, has recently defended the central bank’s record-low rates and other stimulus measures.
As a result, the ECB is expected to cut interest rates even deeper into negative territory and probably restart quantitative easing (QE). As you have read above, the ECB does have reasons to act this way. In addition, other key central banks are also loosening policy, that includes the US Federal Reserve. If the European regulator doesn’t join this trend, the stronger euro will hurt the staggering prices even more.
At the same time, the situation is not that straight-forward. Some ECB members don’t like the idea of more easing at all, in particular, Dutch Governor Klaas Knot and Germany Governor Jens Weidmann. Austria, France, and Estonia have also expressed skepticism about QE. Moreover, the market is currently expecting the ECB to be quite aggressive in its easing steps. As a result, it might be difficult for the central bank to live up to these great expectations.
The outlook for the EUR
On the one hand, the ECB head has pledged to support the economy and keep inflation closer to the target level and the lack of the promised easing will land a blow on its credibility. On the other hand, the ECB has already done much and maybe almost run out of ammunition to make a real impact on the economy and financial markets. Such ambiguousness obviously makes the ECB decision less predictable and the euro’s reaction more volatile.
All in all, we can see the following scenarios:
- The ECB delivers both a deposit rate cut and QE. EUR/USD goes to 1.09 and probably lower, but only for a short period of time.
- The ECB only cuts the deposit rate. After the initial volatility, EUR/USD strengthens to the 1.12 area.
All in all, if we sum everything up, the upside risk for the euro after the meeting looks significant. Note also that it will be very important to listen to the message of the regulator as it might set a longer-term trend for the single currency.