Yesterday, it was reported in the financial press that even the members of the Monetary Policy Committee don’t know what will happen at tomorrow’s ECB rate decision. The Financial Times classified the meeting as the hardest to predict since the hiking cycle began. That means the market is likely wholly unprepared for any eventuality, which could mean a strong reaction in the currencies.
ECB President Christine Lagarde did not provide much in the way of guidance ahead of the meeting. Rather, she insisted that the decision will be based on the data. ECB members who spoke right before the blackout period showed they were divided on the outlook, and also said it would come down to the data.
Trying to piece together a forecast
The problem is that the data hasn’t shown any clear direction. Core inflation did come down a little bit, but it’s still at the same rate it was back in May. It’s still too early to conclude whether the bump higher through June and July was an outlier, or the signal of a new trend. At 5.3%, inflation is way above the target rate.
On the other hand, the economy has been underperforming. Q2 GDP was revised down in the final reading to just 0.1%, leaving the shared economy perilously close to a recession. The European Commission on Monday cut its forecast for growth this year, and expects Germany to fall into recession. Further hiking would only exacerbate those problems, and provide a reason for the otherwise hawkish Germans to potentially not be as enthusiastic about supporting rate hikes.
It’s a cliffhanger decision
Money markets are pricing in a 45% chance of a rate hike at the meeting, which has been rising since the start of the week. It appears that traders are starting to take more notice of the warning ECB member Klaas Knot (The Netherlands), that the market hasn’t fully dimensioned the risk of a rate hike. But, with the balance being so close, the lack of consensus means the market could react quite strongly no matter what happens.
Analysts suggest this might be the last opportunity to hike before the release of Q3 figures. If the shared economy tipped back into negative growth (as PMIs suggest), then it would be hard to make the case for another hike. On the other hand, the market doesn’t seem to agree with that assessment. While it’s about 50-50 for a rate hike in September, the risk of a rate hike by the end of the year is priced in at 80%. Meaning there is a strong consensus among traders that the ECB might follow the same pattern that the Fed could do: Pause in September, hike for the last time in November.
Lining up expectations
A pause now and a strong suggestion that there will be a rate hike in November might split the difference between hawks and doves. This could be the most confusing for the markets, that could see the Euro dropping initially on the rate hold. Then that could fade or move into a rally depending on how convincing Lagarde is in the post rate decision presser.
The other option is for the ECB to take on an unconventional measure in an effort to fight inflation without hurting the economy. Such measures could be raising the reserve requirements ratio of banks, which would cut back excess liquidity while not raising the cost to borrow. But, that comes with its own level of risks. The market could react with even more uncertainty to an unconventional measure, as it would take time to process the potential implications.
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