Is it time to reassess hawkish expectations?

The ECB meeting on Thursday is the next key event that the markets are focused on. The market is rolling back expectations that the ECB will announce any details about tapering its Asset Purchase Programme (APP), after the 3% rise in the EUR/USD since Draghi mentioned “reflation” in a speech at the end of June. This has knocked some of the wind out of EUR/USD’s sails, and it is the weakest performer in the G10 vs. the USD so far today.

ECB to put the brakes on taper talk

We expect this meeting to be a bit of a damp squib, largely because the economic backdrop is relatively unchanged since the last meeting 6-weeks’ ago. The market has been expecting a fall in unemployment and stronger growth across the region to stoke inflation pressure, however that has yet to materialise. The latest price data for the currency bloc has remained at 1.3%, with core prices a mere 1.1%, well below the ECB target of 2%. With such low inflation pressure, it is difficult to see how the ECB can announce any changes to its APP programme. Reports on Wednesday suggest that ECB staffers have begin a programme that looks at how to stop the APP programme. The interesting thing about the story is that it suggested that an announcement from the ECB might not be made in September, as some expect. Instead, the ECB’s APP programme could be around for some time.

We still believe that the future for the euro is higher, however, it may not be a straight line to 1.20 for EUR/USD. Thus, a dovish Draghi, who may choose to focus on weak inflation pressure and ignore any prospect of tapering the APP programme, could see EUR/USD fall back to the 1.1330 lows from earlier this month. Also worth noting, German ZEW data from earlier this week showed a weakening in German investor confidence, possibly as a result of the strong euro, which may be another reason why the ECB will err on the dovish side at its meeting tomorrow.

Could Draghi shock the market once again?

Of course, the bigger shock would be if Draghi does announce a taper, which is looking unlikely. If he does then we would expect EUR/USD to continue on its steep path to 1.20, and for European sovereign bond yields to rise. However, it could be bad news for the Dax index, which has recently experienced a negative correlation with the EUR/USD, after the two moved in unison for most of this year. A 120-day correlation analysis of EUR/USD shows that the Dax index tends to move a negative 0.13% when the Euro moves higher, and vice versa. This is a fairly muted reaction, but it could strengthen if we see larger moves in the euro on the back of this ECB meeting.

GBP stabilising, but still looking weak

Elsewhere, the pound has stabilised around $1.30 after yesterday’s decline on the back of the first drop in CPI since October. This has reduced the prospect of a rate hike from the BOE, with the market still only pricing in the prospect of a 0.25% rate hike by the end of 2018 at 38%. GBP/USD has been hanging around the lows from Tuesday, whether or not it can pick up could depend on the outcome of tomorrow’s ECB meeting, as a general weakening of the euro could boost the pound.

BOJ to stick to its dovish mantra

USD/JPY is facing a key technical test as the death cross, when the 50-day sma threatens to cross below the 200-day sma, could be saved by a dovish Bank of Japan on Thursday. We expect the BOJ to maintain its QE programme and its dovish stance. If this happens then USD/JPY may stand a chance of recovery. However, USD/JPY is a symbol of the overall sogginess in the US currency, which remains hindered by weak economic data, political gridlock in Washington and reduced expectations of a Fed rate hike, the CME Fedwatch tool is now not expecting a further rate hike from the Fed this year. It is hard to muster enthusiasm for the USD, however, it is getting close to levels where it is starting to look good value, thus it may not fall in a straight line from here.

A quick word on US banks…

Elsewhere, bank stocks are back in focus as we wait for Morgan Stanley to release its results later today. The financial sector in the Dow Jones fell 1.25% yesterday, led lower by Goldman Sachs, which continued to fall into the end of Tuesday’s session, a bearish sign, after its bond trading volumes fell by 40% in Q2. Since financials had been attracting volumes in recent weeks as tech fell out of favour, a weakening in the banks could spell bad news for US equity indices over the next few weeks.