Image © European Central Bank
The Euro is the focus of the day as the European Central Bank looks to cut interest rates by 25 basis points and issue new guidance.
It is the shape and form of that new guidance that will interest currency markets, given the rate cut itself is already baked into the Euro.
"We expect the ECB to maintain its 'dovish' tone, supporting current market pricing for around three further cuts over the rest of the year," says Kristina Clifton, Senior Currency Strategist at Commonwealth Bank.
If the assessment is correct, it should weigh on the Euro, allowing for further gains by Pound Sterling and Dollar:
- The Euro to Pound Sterling exchange rate (EURGBP) has been trending lower since February 22, and a 'dovish' ECB can help it extend the move (Pound to Euro rate goes higher).
- The Euro to Dollar exchange rate's recovery rally looks to have peaked for now and further weakness is possible if the ECB signals a desire for further cuts.
"EUR/USD remains firmly below its 200-day moving average (1.0770), reinforcing the broader bearish bias," says Boris Kovacevic, Global Macro Strategist at Convera. "The eurozone economy remains fragile, with stagnating growth and rising risks of a technical recession."
The Eurozone economy is developing some slack, which the ECB will want to remedy with another rate cut.
CBA's Clifton explains that confidence is rising at the ECB that inflation will fall back to the 2% target later this year, despite December's uptick to 2.4%/yr.
"Economic growth has stagnated thanks to weak manufacturing activity and tepid consumer demand. Persistent political turmoil in Germany and France has added to uncertainty about the Eurozone growth outlook," she says.
The ECB is expected to cut interest rates in every meeting but one in the first half of the year, which is more than expected of the Federal Reserve and the Bank of England, making a fundamental case for Euro weakness against the Pound and Dollar.
Yet, this divergence has long been expected, and the ECB will need to 'outdove' existing expectations to drive further material weakness in the Euro.
This could be a high bar to leap, and this suggests the odds of an all-out rout of the Euro are limited.
Chris Turner, head of FX analysis at ING, says there are downside risks to the Euro if the market believes there is a chance of the ECB taking policy below neutral.
Neutral refers to the level of interest rates at which they are neither restrictive or stimulatory. Unfortunately for central bankers, the neutral rate is a bit of an enigma, as it is not static.
"Today's main topic of discussion could very well be the neutral rate, which is generally estimated to be around 2.25%. For reference, the low point in the ECB easing cycle was priced near 1.50% in early December and is priced at 2.06% today," says Turner.
ING economists think the ECB can cut rates to 1.75% in the second quarter, "so clearly there is some downside for short-dated EUR rates and the euro if we're right," Turner adds.
Euro Rebound Potential
Eurozone inflation rose to 2.4% in December from 2.2% and core inflation remained stuck at 2.7% for a fourth consecutive month.ar
On this basis, the ECB will note that core inflation in the Eurozone is not falling as fast as it would like, and this risks a delay to the fall in the headline rate of inflation to 2.0% on a sustained basis.
Also, Eurozone economic activity appears to have improved early in 2025, according to the January PMI reports, giving the ECB reason to maintain a cautious data-lead approach to further rate cuts while keeping its messaging broadly unchanged from the previous meeting.
The Euro would potentially recover in the event that the ECB places a greater emphasis to the improvements in the most recent data.
The ECB decision comes in the context of the Federal Reserve's decision on January 29 to maintain interest rates at unchanged levels, while guidance fortified expectations that the Fed will only cut once in 2025.
The ECB might not want to diverge too far from the Federal Reserve in order to maintain financial stability in currencies and interest rate markets. This will provide further reason to try and keep guidance relatively unchanged when compared to that issued at the previous meeting.