The European Central Bank will try to show that it is serious about hitting its new inflation target when it concludes its meeting at 11:45 GMT on Thursday, likely by locking itself into negative rates for longer. This could solidify the upcoming divergence with other central banks raising rates, which is bad news for the euro.
ECB President Lagarde has promised to deliver new political signals at this meeting, so it should be interesting. The central bank has not been able to sustainably meet its inflation target for a decade now, and yet it raised that target earlier this month. Now he wants to demonstrate that he is determined to achieve this higher goal.
This means signaling that negative interest rates are here to stay. If the ECB is really serious, it could also signal more quantitative easing for longer. As it stands, the pandemic asset purchase program will end next year. Policymakers want to stress that stimulus will not automatically be reversed because of this. They could extend this program or replace it with something similar.
Another option is to decouple forward guidance on interest rates and quantitative easing. Until now, the ECB kept repeating that it would end asset purchases shortly before raising interest rates in the distant future. Separating the two would mean that asset purchases could continue even after the rate hike.
The bottom line is that the ECB doesn’t want the markets to think it is heading for the exit like the Fed or the Bank of England do. He wants to stress that he will stay in cheap money policies much longer. In this way, it gains credibility on inflation.
The latest developments in the euro area support the cautious stance of the ECB. While reopening momentum is still strong, the Delta variant is spreading like wildfire, threatening the economic outlook.
Spain, Portugal and the Netherlands have recently seen new outbreaks of covid, despite widespread vaccinations. Although hospitalizations and deaths are still low, slight restrictions to control the spread are plausible. In fact, parts of Spain have already imposed new curfews.
We’ll see how the economy is doing early on Friday when the PMI surveys for July are released. These tend to be a big event for the euro. Forecasts point to an overall improvement in PMIs, with a slight slowdown in the manufacturing sector more than offset by an acceleration in services.
Policy divergence is bad news for the euro
All in all, with the ECB locking itself into negative rates but the Fed and other major central banks moving towards rate hikes over the next few years, the euro / dollar outlook looks negative. The last time these two central banks drifted in opposite directions was in 2014-2015, when the euro / dollar was decimated.
What is the main risk around this sight? This is probably the Delta variant. Not only has it infected several countries in Europe, but it is also ravaging Australia and Asia, causing further lockdowns. Emerging market economies are very vulnerable given their low vaccination rates.
If this impacts global growth, it could slow down the Fed’s normalization plans, potentially raising the euro / dollar. That said, it is unlikely that derail these plans. The Fed is going to normalize further, it might just take longer until we get there, so the overall euro / dollar trend still looks negative.
From a technical perspective on the pair, further declines could meet support near the 1.1700 handle, a potential breakout of which would turn attention towards 1.1620.
On the upside, if the ECB does not seem accommodating enough or if worries about global growth make the Fed hesitant, initial resistance to advances could come from the 1.1880 area. If the Bulls get over that, their next target could be the 1.1980 region.