The euro has been brutally knocked down by the US dollar lately and the big question now is whether the Eurozone’s impelling calendar events could help the common currency find its feet this week. The European Central Bank’s policy announcement will be the major highlight on Thursday at 12:45 GMT. Although no changes are expected, traders will be eagerly looking for any hawkish language twists, especially if those follow stonger-than-expected preliminary CPI inflation readings and a smaller unemployment rate on Tuesday. Retail sales will be next watched on Friday, but the US nonfarm payrolls could steal the show later in the day.
ECB to stay out of the hawkish club
While several major central banks have unwrapped or have already put their rate hike plans into action, the ECB is among the few which are still not willing to join the hawkish club. Although Eurozone’s inflation topped at a historically high of 5.0% y/y in December and policymakers project an above-target average rise of 3.2% this year, ECB chief Christine Lagarde has clearly telegraphed that an increase in interest rates is unlikely in 2022. Of course, she underlined that the central bank would do its job if its “inflation criteria are satisfied”, but as long as its forecasts point to a slowdown below 2.0% in 2023 and 2024, there is no need for discussion yet.
Investors, however, are not very convinced. Despite some stabilization in inflation expectations for the next year and for the following two and five years as reflected in inflation swap rates, they believe that two rate hikes of 10-basis-point modest rate hikes of up to 20 basis points are possible this year, starting in September the earliest, while some others bet that interest rates will crawl up to 0% by the end of 2023.
Inflation may keep teasing monetary policy in the future
Well, perhaps markets are right and reasonably influenced by some key dovish ECB policymakers who have recently said that investors should not attach too much importance to the prospect of price growth falling below the 2% goal in 2023 and 2024.
In addition, the key driver behind the price acceleration is the elevated cost of energy products, marking a 26% annual growth in December. Besides the prolonged boost from the pandemic related supply constraints, the European Union’s seven-year Next Generation programme, which aims to make the bloc the world’s first carbon-neutral region by 2050, could also contribute to higher prices if member states face tougher carbon-energy taxation.
In the financial world, the eurozone’s bond market could face more damage if higher interest rates in other regions encourages investors to move their funds out of the bloc. Hence, a wide divergence from other central banks could leave the ECB at a disadvantageous position. Simultaneously, the euro may keep trending downwards in the face of a dovish ECB, making imports more expensive. The latter could result in additional inflation pressures.
Economic recovery in focus
Still, the above could be a longer-term problem. At the current juncture, the eurozone’s economic recovery is lagging other advanced regions and is far from certain. Unlike US GDP, which surpassed its pre-pandemic levels during the summer, expansion in the 19-nation bloc has not breached that threshold yet. Of course, the unemployment rate has returned to normal levels, but it is still well above the ones in the UK and the US, while its trade balance has sharply deteriorated, posting a deficit in November for the first time in more than eight years.
Not to mention its political landscape, which could face more hiccups later in the year when the French election takes place, while rising tension in Eastern Europe could generate more anxiety.
Same dovish tune but some hawkish beats could move the euro
Hence, the central bank could sing the same dovish tune for now to keep markets calm, but it could balance its tone with some hawkishness to count for the inflation uncertainty, perhaps by reiterating December’s statement that monthly regular asset purchases will be diminishing after the pandemic-led PEPP program ends in March but adding that a faster pace of reductions will also be considered if the inflation situation worsens.
Turning to FX markets, unless investors translate some of the language into new hawkish twists, a steady policy by the ECB may not aggressively move the euro. Nevertheless, Wednesday’s CPI inflation figures for January could send some earlier signals about the central bank’s stance, likely creating some volatility ahead of the meeting. Expectations point to a slowdown to 4.3% y/y from 5.0% before, though an upside surprise cannot be excluded given the faster-than-expected growth in German flash CPI readings. If forecasts are right, inflation would still be among the highest over the past three months, but the pullback in CPI measures could still justify an accommodative attitude, with the euro likely extending its weakness towards the 1.1000 level against the dollar in the aftermath.
Otherwise, if the data come in stronger than expected, with the unemployment rate declining below the 7.1% forecast, the ECB may find it hard to control investors’ rate hike projections. In this case, euro/dollar may attempt to crawl above 1.1185 and run towards the 1.1235 nearby barrier. Higher, the focus will turn to the 1.1300 mark.
