ECB preview – disappointment for euro bulls?

Expectations of a hawkish shift in policy at this week’s ECB meeting are high, but given the still uncertain outlook, perhaps renewed bullishness on the euro is premature. 

Source: Bloomberg

This week’s European Central Bank (ECB) meeting comes at an interesting time, as the bank meets to potentially discuss scaling back quantitative easing (QE) barely a month after a new government in Italy threatened to up-end the delicate consensus in the eurozone.

Usually, hints on policy come from anonymous ‘ECB sources’, but last week’s decision by the chief economist, Peter Praet, to make statements about the QE programme could represent a major shift. It looks like the bank is prepared to discuss moving towards an end date for its QE programme, even if that date is still further away than many expect.

To give the ECB its due, it does look like the eurozone recovery is firmly in place. As we discussed in a previous article, the eurozone economy is still seeing increased strength, with unemployment falling overall and consumer spending rising. Even recent weakness in the composite purchasing managers index (PMI) is not necessarily a cause for concern, given the overall strength of the past year.

Inflation has also begun to pick up, with consumer price index (CPI) rising to 1.9% for May, close to the bank’s 2% target. Sustained price growth above this level has yet to be seen, but the overall trend is still higher from the lows of early 2016.

I suspect that the market may have got ahead of itself slightly with the move higher in the euro following Praet’s comments. The eurozone recovery is in place, but Italy sends a warning signal that the work is only half done. While the cracks in the eurozone have been papered over, there is still a very real sense of discontent in southern European countries. With Italy bearing the standard, those unhappy with the current system may find it easier to make their voices heard. Such tensions would inflame bond markets, requiring the ECB to maintain its role as a backstop.

As we learnt with the Federal Reserve (Fed), an end to monthly bond purchases would also not necessarily signal a complete stop to QE. The reinvestment of proceeds from the programme would continue, providing an ongoing form of monetary accommodation.

Unless the bank talks about the possibility of interest rate rises, still viewed as a very distant prospect, the euro bulls may find themselves lacking foundation for further rallies. While the QE programme is officially meant to end in September, ECB president Mario Draghi may opt to extend it to the end of the year, but at a reduced rate, perhaps €10 billion per month rather than the current €30 billion.

The lack of an explicitly hawkish commitment at this meeting could well put further downward pressure on the euro. CFTC data continues to show a reduction in net euro longs, down from their record highs in January. Without a firm move in the direction of tighter policy, the euro seems to be poised for further weakness.

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