So it's the ECB meeting tomorrow and while inflation is running hot in the Eurozone, it seems likely we are going to have some significant pushback from the ECB (especially Lagarde) as they are determined to try and continue to support the recovery.
To start with, I think it's interesting to just have a quick look at EURUSD performance over the last few days. The chart below shows EURUSD since the start of the month and you can see we are basically in the middle of those recent ranges - hovering around the 1.16 mark with no real decisive moves in either direction.
This certainly seems like the market is waiting for something, and that thing could well be the ECB meeting tomorrow.
What does the market expect?
Well inflation continues to be the topic on everybody's mind, so if the ECB is to maintain its credibility it will at least need to talk about what this higher level of inflation means for the Central Bank. I have flagged a couple of times a chart from John Authers in a BBG newsletter (below) which shows how inflation in Germany at least is presenting a real challenge for the ECB.
But in reality, despite the inflation conundrum, we all know the ECB is going to do nothing except keep its foot hard down on the gas pedal. Last month, Lagarde said the ECB is "pretty far away" from raising rates and it seems likely that this narrative will persist (the cynical among us probably agree that the ECB will never hike rates again...)
But perhaps this overlooks the fact that Eurozone inflation is expected to come in at a 13-year high of 3.7% in October. Wowza.
How does this all intermingle with the new framework?
You'll remember that a couple of months ago the ECB announced a new policy framework where it would now target 2% inflation more symmetrically than previously. To me, the dovish shift means that there will be even higher criteria to be met before the ECB even considers talking about raising rates. Likewise, with the still "transitory" nature of inflation largely concerning global supply chains and energy costs, it seems to me that the ECB will be able to look through this inflation easily since it is powerless to do anything about it.
What will be more interesting will be to see if there are any signs of dissent among council members. Several members at last month's meeting started to become a bit more hawkish and began to expect higher inflation than what ECB forecasts officially suggest. The question is, does this minority start to develop into a more hawkish group. It is easy to imagine a situation when some members (especially those inflation-wary Germans...) start to adopt a more hawkish stance.
In fact, looking over the last few months there has been a clear trend in the direction of Schatz (2y German bonds) yields... higher. In my view, the market here might just be getting a little ahead of itself on the prospect for any kind of ECB tapering.
A graphic I particularly want to flag is the one below as it outlines a few nice scenarios which I broadly agree with. The base case is that Lagarde will acknowledge, and only acknowledge higher inflation with a view that it will fall later on in 2022. The risks to the economy remain, and there will be no change to any of the policy tools.
My one main concern about the base case, and perhaps only disagreement with the graph, is that the EUR has become markedly weaker in recent months, so this could perhaps further play into the inflation story. Nonetheless, I doubt Lagarde will make explicit comment on the currency tomorrow anyway.
The only slight disagreement I have is on the hawkish side - where I think these levels are too bullish for the commentary likely. If we get the "hawkish talk" I'd expect a 1.168 level, and for the "very hawkish" I'd see a 1.175.
Either way, I agree with the general thesis the risk for EURUSD is to the downside, but I maintain my general view for the medium term for EUR to trade between a 1.15 and 1.17 for the rest of the year.
As always, hit me up with any questions / ideas / trades.
I won't be in EURUSD before the meeting, but I might put a trade on after. I'll keep the email distribution list members updated first - so if you'd like to be added... please use the form up on the top right.
Good luck all.
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