On the eve of the European Central Bank’s monetary policy announcement, Euro dropped to a 3 month low versus the U.S. dollar. Everyone expects the ECB to maintain their dovishness especially after they tweaked their inflation target but the relatively minor declines in EUR/USD this month suggests that sellers may be exhausted. This poses a risk for anyone anticipating further losses in EUR/USD following the ECB announcement. The central bank has given traders plenty of time to price in dovishness and their decision to set a new inflation target two weeks before their policy decision was intended to mitigate volatility when the details are released – all of this suggests that EUR/USD could rally on ECB day.
We’ve seen it before – where central banks are dovish and the currency rallies or vice versa. How EUR/USD reacts to ECB is a function of market expectations. Going into this week’s rate decision, investors expect the central bank to confirm that their change from a “below but close to 2%” to a “symmetric 2%” inflation target that means they may be more relaxed about consumer price growth above 2%. In June EZ CPI dropped to 1.9% from 2%. At first glance it appears that they’ve put themselves near the end of the line for tightening but if ECB President Lagarde suggests otherwise on Thursday, EUR/USD could soar.
While Eurozone data has been mixed, the recovery should be gaining momentum. Many European nations eased restrictions and are welcoming back tourists. Confidence is at its highest level in more than 2 decades according to the European Commission’s sentiment index with economic activity bolstered by reopenings for restaurants, shops and other services. Should the ECB express any degree of optimism, EUR/USD could rally on the mere hope that taper is still on the table despite the inflation change. If Lagarde takes this one step further and says they have begun to talk about the possibility of reducing asset purchases, EUR/USD could verticalize towards 1.19. The point is that considering how much EUR/USD has fallen, it may not take much for EUR/USD to rally on ECB Thursday.
U.S. stocks continued to recover from Monday’s losses and this time all of the high beta currencies participated in the rally. The Canadian and New Zealand dollars were the best performers which should not be a surprise as their central banks are the least dovish. Weaker than expected Australian retail sales held the Australian dollar back but did not prevent it from moving upwards. The U.S. dollar traded lower against all of the major currencies except for the Japanese Yen. With Treasury yields jumping 5bp t, USD/JPY is back above 110. Looking ahead, the ECB rate decision is the main focus but investors will also be watching U.S. jobless claims and existing home sales.
Gold prices are down for the fourth day in a row but the declines have been modest. Between rising U.S. yields and a stronger dollar, the recovery has been brought to a screeching halt. With that said, XAUUSD remains confined to a very tight 1791 to 1835 trading range. If stocks continue to recover and 1790 breaks, the next stop will be 1760.
Kathy Lien Managing Director of FX Strategy BK Asset Management