dovish tune with warmongering rhythms

The Euro has been knocked down sharply by the US Dollar lately and the big question now is whether the compelling events on the Eurozone calendar could help the common currency find its footing this week. The European Central Bank’s policy announcement will be the highlight on Thursday at 12:45 GMT. While no changes are expected, traders will be eagerly looking for any changes in hawkish language, particularly if these follow stronger than expected preliminary CPI inflation readings and a lower unemployment rate on Tuesday. . Retail sales will then be watched on Friday, but US nonfarm payrolls could steal the show later in the day.

The ECB will stay out of the hawkish club

While several major central banks have unveiled or already implemented their rate hike plans, the ECB is among the few that still do not want to join the hawkish club. Although eurozone inflation hit a historic high of 5.0% year-on-year in December and policymakers forecast an above-target average rise of 3.2% this year, the head of the ECB, Christine Lagarde, clearly telegraphed that an interest rate hike is unlikely in 2022. Of course, she stressed that the central bank would do its job if its “inflation criteria are met”, but as long as its forecast points to a slowdown below 2.0% in 2023 and 2024, there is no discussion yet.

Investors, however, are not very convinced. Despite some stabilization in inflation expectations for next year and the next two and five years, as evidenced by inflation swap rates, they estimate that two modest rate hikes of 10 basis points to 20 basis points are possible this year, starting in September at the earliest, while others are betting that interest rates will climb to 0% by the end of 2023.

Inflation may continue to tease monetary policy going forward

Well, maybe the markets are right and are being reasonably swayed by some key ECB policymakers who recently said investors shouldn’t value the prospect of subpar price growth too much. target of 2% in 2023 and 2024.

In addition, the main driver of the price acceleration is the high cost of energy products, marking an annual growth of 26% in December. Besides the protracted push from pandemic-related supply constraints, the European Union’s seven-year Next Generation program, which aims to make the bloc the world’s first carbon-neutral region by 2050, could also contribute to rising prices if Member States face stricter carbon emissions. energy taxation.

In the financial world, the eurozone bond market could be further damaged if higher interest rates in other regions encourage investors to pull their funds out of the bloc. Therefore, a wide divergence with other central banks could put the ECB at a disadvantage. At the same time, the euro could continue its downward trend in the face of a dovish ECB, making imports more expensive. The latter could lead to additional inflationary pressures.

Economic recovery at the center of concerns

Still, the above could be a longer-term problem. At present, the Eurozone’s economic recovery is lagging behind other advanced regions and is far from certain. Unlike U.S. GDP, which surged above pre-pandemic levels over the summer, expansion in the 19-nation bloc has yet to cross that threshold. Of course, the unemployment rate has returned to normal levels, but it remains well above those of the United Kingdom and the United States, while its trade balance has deteriorated sharply, posting a deficit in November for the first times for more than eight years.

Not to mention its political landscape, which could face further upheavals later in the year during the French elections, while rising tensions in Eastern Europe could generate more anxiety.

Same dovish tune but some hawkish beats could rock the euro

Therefore, the central bank could sing the same dovish tune for the time being to keep markets calm, but it could balance its tone with some hawkishness to account for inflation uncertainty, perhaps reiterating the statement. of December that regular monthly asset purchases will decline after the pandemic. The PEPP-led PEPP program ends in March, but adds that a faster pace of cuts will also be considered if the inflation situation worsens.

As for the currency markets, unless investors translate some of the language into hawkish new twists, steady ECB policy might not move the euro aggressively. Still, Wednesday’s CPI inflation numbers for January could send earlier signals about the central bank’s stance, likely creating some volatility ahead of the meeting. Expectations point to a slowdown to 4.3% yoy from 5.0% previously, although an upside surprise cannot be ruled out given the faster than expected growth in German flash CPI figures. If the forecast is correct, inflation would still be among the highest in the past three months, but the pullback in CPI measures could still warrant a dovish stance, with the euro likely extending its weakness towards the 1.1000 level. against the dollar in stride.

Otherwise, if the data is stronger than expected, with the unemployment rate lower than expected at 7.1%, the ECB could struggle to control investors’ rate hike projections. In this case, the euro/dollar may attempt to climb above 1.1185 and run towards the nearby barrier of 1.1235. Higher up, attention will turn to the 1.1300 mark.