Image © European Central Bank
The pound rises against the euro into the ECB event, but that sets it up for a pullback in the event of a 'hawkish' outcome.
The pound-to-euro exchange rate rises to 1.1590 in midweek trade amidst supportive technical structures and a broadly weaker euro, with the single currency showing some nerves ahead of Thursday's important European Central Bank (ECB) decision.
The ECB is expected to raise interest rates 25 basis points, but the softer euro suggests markets are cautious of the central bank striking a 'dovish' tone.
After all, with the rate hike 'in the price' it will be the tone and guidance as to the prospect for further hikes that will determine the financial market reaction.
"The upcoming tightening will likely be framed as a pre-emptive and precautionary ‘insurance’ move. While leaving the door open for further action," says Henry Cook, an economist at MUFG Bank. "With the hike entirely priced, the market focus will be on any signals around the timing or extent of any further tightening."
Money markets show investors are positioned for at least one more rate hike in the coming months, to be more precise, about 65% basis points of hikes are expected, so that's effectively one-and-a-half.
The ECB must reaffirm that pricing to keep the euro on an even keel. Given the pre-event retreat in the euro, we'd imagine that a 'buy the fact' reaction benefits the euro in the event that the ECB is clear it thinks there's a need to raise rates again.
"With a 25bp hike now looking almost inevitable next week, we doubt the ECB will sound dovish enough to prevent the market from assigning a meaningful probability to a second hike in September…or even in July," says Oscar Torres at Santander.
Should the ECB reaffirm a rate hike and the market pares back the euro's pre-event weakness, the pound-to-euro rate (GBP/EUR) would likely come under pressure.
With GBP/EUR rising to 1.1590 it is approaching a significant resistance zone; the pair has been unable to cross and hold 1.16 for more than a year.
To us, that's an important point to consider for those looking for a stronger pound: a slightly 'hawkish' ECB and solid technical resistance open the door to a shallow pullback.
A dip into the mid-1.1550s could therefore be likely in the latter half of the week.
An Insurance Cut
The ECB will be cutting interest rates in response to rising inflation, itself a symptom of the fuel price surge that follows in the wake of the Middle East conflict.
Yet, the Eurozone economy has slowed meaningfully in recent months, meaning there's no guarantee inflation will become entrenched.
That's why the ECB will see the cut as an 'insurance' move; i.e. one that seeks to guarantee there will be no snowball effect in inflation trends.
ECB President Lagarde has herself warned in recent times that credibility is important; the Bank must be seen to be responding to inflation if it is to remain a credible agent when it comes to controlling inflation.
A Dovish Tilt Could Weigh on the Euro
If the ECB packages the hike as an insurance move, and is therefore keen to emphasise optionality on future hikes, market expectations will fall, which would weigh on regional bond yields.
For the euro, that would be a headwind and could allow the GBP/EUR to test 1.16, or even higher.
Economists at Commerzbank remind us that the ECB Governing Council is dominated by proponents of a fundamentally accommodative monetary policy (doves) who understand the desire of highly indebted countries for key interest rates as low as possible.
That's an argument for the ECB to lean dovishly; in fact, they see the ECB cutting interest rates again in the coming months.
"In the second half of next year, with inflation back below 2%, the central bank is likely to cut interest rates in two steps to 2% —returning them to the level seen before the Iran War," says Commerzbank.
If the market senses that looming turn of events, the euro could struggle this Thursday.