EUR and ECB Crib Sheet: Hawkish expectations vs Lagarde’s patience

This week’s European Central Bank (ECB) rate announcement is highly unlikely to bring any changes to the Bank’s policy. Instead, most focus will be on how the ECB addresses the inflation risk and whether there will be any tweaks to rates and quantitative easing (QE) guidance.

Here is a detailed article on what we expect from the meeting: “ECB preview: How to avoid jumping from patience to panic”. In a nutshell, we think that President Christine Lagarde will carefully avoid sounding too alarmed on inflation, and along with the acknowledgement that price pressures are set to remain elevated for most of 2022, the view that core will ultimately ease from late-2022 onwards should remain central. Accordingly, Lagarde should continue pushing back against speculation over a rate hike in 2022.

We look at different scenarios and implications for euro (EUR)/US dollar (USD) – which we discuss in greater detail in the next paragraph – in the chart below.

EUR/USD jumped along with the eurozone’s bond yields on Monday as inflation numbers in Germany beat expectations and suggested prices may prove stickier than what the ECB is currently forecasting. We think this notion, along with the ongoing softening of USD momentum, can offer a floor to EUR/USD into the ECB meeting, as markets price in a greater probability of a hawkish shift.

Indeed, some of those hawkish expectations are already embedded in asset prices, as markets are currently pricing in the start of the ECB’s tightening cycle in 4Q22, despite the ECB’s forward guidance signalling no rate increases until 2023.

It is important to notice that the dollar rally in the second part of January was quite justified by fundamentals (in particular, interest rate differentials) and – as shown in the chart above – it brought EUR/USD from overvalued to fairly valued territory. Incidentally, EUR/USD positioning had advanced into net-long territory before last week’s dollar rally, which suggests that position-squaring-related upside risk for the pair is now limited.