ECB preview; will Brexit force the ECB’s hand?

Market expectations are on the wane for ECB action on Thursday. What would drive a new bout of monetary easing from the ECB and will it ultimately act?

ECB president, Mario Draghi
Source: Bloomberg

Traders have marked their calendars for Thursday’s European Central Bank (ECB) meeting as the core driver of volatility and speculation this week, with the EU referendum result raising expectations of additional action. We look at the core drivers of a possible round of easing from the ECB and the likeliness of it actually happening.

Drivers of ECB action

It is well publicised that the eurozone (like many other countries) is suffering from a bout of disinflation, with the zone suffering negative or non-existent price growth (CPI) for four months prior to the June reading of 0.1%. On top of that, the region continues to suffer widespread unemployment – despite distinct improvements over the past 18 months.

Alongside these economic woes, the referendum result has put another spanner in the works, with weakness in the euro reflecting the dire consequences that could arise from this vote. The eurozone region enjoys a sizeable trade surplus with the UK, which would be under threat should border to trade be put up.

Will it act?

While the ECB will no doubt continue to focus upon its economic indicators, the referendum result is a game changer, hitting investor and business sentiment for the time being. Given the dearth of post-referendum data, there is little to tell us the eurozone is currently in need of a fresh bout of easing. Thus in a similar vein to the Bank of England (BoE), the most likely eventuality is one of Draghi’s dovish specials, where he talks up the chances of easing in the coming months, yet holds off for now.

Last week saw the indices in buoyant mood in the lead up to the BoE meeting, which seems to have served as a lesson given the indecision seen so far this week. As such, the deterioration in expectations appears to have held back the optimism that was so evident last week in european indices.

The chart below highlights the recent shifts in expectations of action for both the July and August meeting, with initial spikes around the referendum falling away heavily. In particular, the inaction from the BoE last week has proven to lower expectations of this meeting. As a result, market expectations are now down to 10% (July) and 40% (August) for a rate cut.

Market impact

Much of the impact will be felt in the euro, which typically reacts to fundamental and economic changes more than indices. EUR/USD has been seeing a double top pattern forming this month and with price currently at the $1.100 neckline, a cut on Thursday would likely lead to a sharp deterioration back down to $1.0912.

The likeliness is that any bounce would be short-lived, dependent on the language used by Draghi. He rarely talks up the euro and as such, any bounce into the $1.108 and $1.1180 resistance levels are likely to be sold into.

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