ECB Preview: The only game in town could be in lockdown, three mostly negative EUR/USD scenarios

• The ECB will likely leave its QE programs unchanged in the April meeting, disappointing markets.
• Waiting for new forecasts, the bank may hint that it is ready to act in June.
• A surprising enlargement of its emergency program could lift the common currency.

Christine Lagarde's late largesse helped stabilize the euro – and potentially Italy's eurozone membership – but this may still prove temporary. The President of the European Central Bank oversaw the launch of the Pandemic Emergency Purchase Program (PEPP) – a whopping €750 billion bond-buying scheme with looser limits than previous ones.

That late-night decision on March 18 corrected Lagarde's previous comment that frightened markets. Only six days earlier, in the bank's scheduled decision, she said it is not the ECB's job to take care of spreads, weighing on Italian bonds and the euro. The bloc's third-largest already had a high debt-to-GDP ratio before the crisis and has been struck by the virus.

The bank has been deploying the cash at a rapid pace:

Source: Trading Economics

With a total of €1.1 trillion of buying in 2020, the ECB also bought politicians time to play out their differences and come up with a forceful economic response to COVID-19. However, the ECB proved to be the "only game in town" as Mario Draghi, Lagarde's predecessor, said. 

Instead of coming together, fissures from the debt crisis from the recent past only became more extensive. France, Italy, Spain, and other countries initially demanded "coronabonds" – European mutual debt to help the economies recover and provide confidence to investors. On the other hand, Germany rejected sharing the debt, and the Netherlands wanted hard-hit countries to use the ESM bailout mechanism.

Lagarde backed coronabonds as a one-off exercise in the face of the emergency and also warned of a 15% crash in Europe's economy in the worst-case scenario. Leaders eventually settled for a compromise package of €500 billion and unrestricted use of the bailout fund – albeit at a limited scope. Ideas funds worth €1.5 to €2 trillion did not pass muster in the virtual EU Summit on April 23.

The ball now returns to Lagarde's court. Will she show more largesse and push for more buying? Governments have been holding back with fiscal stimulus, and unleashing more monetary tools would allow them to spend and help the economies recover as they gradually reopen. 

Here are three scenarios for the ECB meeting and implications for EUR/USD:

1) No action – EUR/USD suffering 

The ECB President and several of her colleagues may want to push through with enlarging the PEPP to over €1 trillion already now. However, similar to politicians, the central bank is also divided alongside north-south lines. The hawkish camp led by Jens Weidmann, President of the German Bundesbank, will probably reject any additional injection within a month, despite the emergency.

In case the Frankfurt-based institution leaves its policy unchanged and fails to pledge future action, EUR/USD would fall. The old logic saying that printing more money means devaluing the currency does not apply, as the funds allow stimulating the economy. The absence of recent action could, therefore, depress the common currency. This scenario has a high probability as the wind is blowing in favor of the hawks. 

2) Waiting for June – EUR/USD probably suffering

Lagarde and her colleagues may cook a euro-fudge – kick the can down the road to the next meeting. The Frankfurt-based institution publishes growth and inflation forecasts at its next meeting in early June and may wait for that and additional developments. Besides, several countries are gradually easing restrictions through May, and that provides more clarity. 

During the next six weeks, Lagarde would have time to convince the hawks to go along, but she may already hint in the press conference that the most likely move in June would be announcing more stimulus. In that case, it is unclear if markets would be convinced, and the reaction depends on the language.

If she vows to do whatever it takes, echoing Draghi or promises a big bazooka, markets may be impressed, and the euro could rise. If the readiness to act is conditional on the data, the common currency could fall. Given her mismanagement of the March 12 meeting, markets may question her move, volatility may rise, and EUR/USD may eventually decline. The scenario has a medium probability.

3) Action now – EUR/USD rises

Does the bank know something politicians do not? Perhaps the staff in Frankfurt has produced new economic analysis and may convince the Governing Council to act sooner rather than later. Moreover, the ECB may opt to step into the ground that leaders ceded and provided more assistance. 

If the bank announces an imminent enlargement of the PEPP, injecting more money into markets, governments could raise more funds and stimulate the economies. The mere announcement would send EUR/USD shooting higher, as markets do not price this low-probability option.

Conclusion

The ECB faces a dilemma amid the coronavirus carnage and the weak response from leaders. After nearly quadrupling its bond-buying scheme, the bank has more room to act, and southern governments would undoubtedly appreciate that help. However, the most likely scenario is for a pause at this juncture, and that may weigh on the euro. 

More Coronavirus: Lack of leadership may lead to L-shaped economy, markets may suffer badly