EUR & ECB crib sheet

FX markets will be closely watching two aspects of the upcoming European Central Bank meeting this Thursday: the potential top up of the Pandemic Emergency Purchase Programme and President Christine Lagarde's communication, with both being closely tied to the perception of the euro risk premia.

PEPP programme: We see a further increase in size (from the current EUR 750 billion to EUR 1.250 trillion) and scope (adding fallen angels - high yield debt) as likely, though the timing is uncertain. It may already happen this week, but given that the new set of ECB staff forecasts is only delivered at the June meeting, the ECB may opt to wait (see ECB Preview for details), particularly as the BTP-Bund spread has narrowed in recent days and the 10-y BTP yield is back below 2%. However, even if the increase in PEPP is not announced this week, we think it likely that the ECB's communication will hint at an eventual increase in purchases at the June meeting, in turn preventing a disappointment induced sell-off in peripheral bonds and the euro. See the ECB cribsheet above for details and various scenarios.

The press conference: This will be a closely watched factor following President Lagarde’s unfortunate communication at the March meeting, which gave rise to fears of the risk premium being re-introduced to the common currency (as Figure 1 shows above, the euro risk premium increased substantially after the March meeting, by around 2%). We see it as unlikely that President Lagarde would want to repeat the mistakes of the past and communicating a commitment to do 'whatever it takes' to help the eurozone economy and ensure financial stability would be supportive of the euro this week.

Given that EUR/USD trades modestly below its short term fair value (Figure 2), meaning that some risk premium associated with the ECB communication looks to be partly priced in, positive signals from the ECB this week could bring EUR/USD to / above the 1.0900 level this week.

With the ECB preventing the euro risk premium from re-building and the US dollar no longer getting the indiscriminate support from the USD funding squeeze and a previously high interest rate differential (both in Figure 3, with the former being tactical and the latter strategic advantages - which have now faded) we expect EUR/USD to slowly grind higher, towards the 1.15 level this summer as the broader USD weakness unfolds.