ECB Preview: Three things that may tilt EUR/USD to the downside

The last meeting before summer kicks in was supposed to focus on the details of the European Central Bank's new funding scheme called TLTRO. However, life has had other plans for ECB President Mario Draghi and his colleagues. 

Background: What has happened since the last meeting

Growth: We begin with the good news – euro-zone growth has accelerated to 0.4% in the first quarter after two disappointing quarters of only 0.2% beforehand. The figures have been encouraging to the ECB and confirm its assessment that the recent slowdown does not consist of an outright risk of an imminent recession. 

Inflation: The preliminary inflation figures for May have badly disappointed with a drop of headline inflation to 1.2% year on year. Core CPI has fared worse with only 0.8%. The latest figures cannot be blamed on seasonal effects. The ECB is missing its 2% goal and by a larger margin than it had anticipated. 

Trump: Trade talks between the US and China broke down in early May and the trade war has been intensifying. The world's largest economies have been slapping tariffs, limiting the other country's companies' activities, and upping the rhetoric against each other. President Donald Trump has reopened the Mexican front and Europe is not spared either – the US has kept its threat to hit the EU with levies on cars and car parts. When Draghi says that "risks are moving to the downside" he lists protectionism as one of the first reasons – and trade wars are of increasing worry now.

All in all, the picture has darkened since the last meeting. 

How will the bank respond? When the ECB releases its statement on Thursday at 11:45 GMT, it will surprise no one by announcing the details of the new TLTRO funding scheme. However, another section of the document will be of high-importance to markets.

Here are three things to watch out for:

1) Guidance on interest rates

The ECB has pledged to keep interest rates at current or lower levels until at least the end of 2019. The current commitment is an extension of the previous one – that was limited to the end of the summer. The promise to depress interest rates serves as stimulus as businesses are more confident that their lending costs will remain low.

Recent inflation data and fears that Europe may suffer a downturn due to commerce disputes may prompt the Frankfurt-based institution to push back its guidance to the spring or summer of 2020 – well beyond Draghi's term which ends in November 2019. 

If the ECB takes this path, the common currency may fall sharply regardless of what Draghi says afterward. However, the governing council and especially its hawkish members may prefer to wait longer and leave the text unchanged. 

In this case, other factors come into play.

2) New forecasts

Draghi begins talking at 12:30 GMT and his opening statement will include fresh forecasts by his staff. Minor downgrades to growth and inflation forecasts are on the cards. Central banks tend to acknowledge reality by making substantial adjustments to the current year's outlook while remaining optimistic about the future.

The recent deceleration in inflation will likely force a significant downgrade to the ECB's 2019 outlook – and that is priced in. If it takes further steps and become pessimistic for 2020, the euro may have room to fall. On the other hand, if Draghi and his colleagues surprise with optimism, the common currency may rise.

3) Wording on protectionism

The third factor cannot be quantified but is no less important. Draghi may sharpen the language regarding trade, laying out a bleak outlook. He may say that downside risks have materialized or called on governments to take urgent action. 

His prepared remarks may carefully balance a warning about risks of deterioration and optimism that politicians will eventually resolve the differences. Draghi may only reveal his full approach in the lengthy Q&A session that follows. If the seasoned central banker expresses graver concern than in the scripted statement – something that has happened in the past – the euro will have more room to fall.

Yet if he remains optimistic, markets will only digest his previous words to decide how concerned he was – and the verdict may come only after he concludes his press conference. 

EUR/USD is vulnerable

The USD has weakened amid mounting speculation that the Fed will cut interest rates in response to falling inflation and trade uncertainty. However, it may have already run its course. 

When Fed Chair Jerome Powell opened the door to a rate cut, the greenback initially dropped but then recovered quite quickly. It seems that the dollar's downfall – justified or not – has run its course.

Another factor weighing on the world's most popular currency pair is its limited trading ranges. Low volatility may frustrate traders but it provides predictability. EUR/USD has emerged from the lows, and may now fall back down towards the 2019 lows.

Conclusion

The ECB will present the new funding scheme but markets will focus on changes to the interest rate guidance, new forecasts, and the bank's stance on the impact of trade. Recent developments have been unfavorable, implying a more dovish tone from Draghi and his colleagues. There is a significant downside risk – as not everything is priced in.