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EUR/USD. Trapped in inflated expectations: ECB July meeting preview

The European Central Bank will sum up the results of its next – July – meeting on Thursday. This is by no means a “passing” meeting: for the first time in the last 11 years, the ECB will raise interest rates.

By itself, the fact that there will be an increase in the rate has already been resolved, the intrigue remains regarding the magnitude of this increase. In addition, traders are interested in further prospects for tightening monetary policy amid existing risks for the debt market. In other words, the results of tomorrow’s meeting will surely provoke strong volatility for the EUR/USD pair. The only question is, on whose mill will the water be poured. If the central bank surprises with an ultra-hawkish tone, the pair could not only test the 1.0300 resistance level, but also consolidate in the area of the 3rd figure. Otherwise, the euro will again be under pressure throughout the market. In my opinion, current market expectations are somewhat overstated, so there is a possibility that the ECB will not live up to its hopes on Thursday.

It is worth noting that a few weeks before the July meeting, traders actually resigned themselves to the fact that the ECB would gradually and measuredly tighten monetary policy. Representatives of the ECB have repeatedly said that it is impossible to sharply raise the rate to curb inflation – primarily because of the risks for the debt market. Just last week, a member of the Board of Governors of the central bank, Olli Rehn, announced that at the July meeting the rate would be increased by 25 basis points. Similar forecasts have been voiced by ECB President Christine Lagarde and some other members of the Board of Governors.

With such a wide-ranging and unequivocal preview, the market has grown accustomed to the idea of a 25-point advance in July. All attention was focused mainly on the prospects for further steps by the ECB, primarily in the context of the September meeting.

However, the day before yesterday, the market was stirred up by journalists from the news agency Reuters. Referring to their anonymous sources in the ECB, they said that the option of a 50-point rate hike is still on the agenda. At the same time, agency reporters quite recently (July 15) interviewed more than 60 economists about the possible outcomes of the July meeting. 62 out of 63 experts surveyed unanimously stated that the central bank will increase the rate by 25 points. In this case, economists reflected market expectations, which until recently prevailed among traders. However, insider information from Reuters, as they say, mixed all the cards.

Amid these hawkish rumors, the euro has significantly strengthened its position against the dollar. Bulls were able to move away from the parity level by more than 200 points, updating a two-week price high on Wednesday, rising to 1.0274. But, in my opinion, this is a Pyrrhic victory for the EUR/USD bulls, which could have negative consequences for the euro.

In fact, EUR/USD bulls are repeating the mistake of the dollar bulls, who were inspired last week by rumors that the Federal Reserve could raise rates by 100 points at once following the results of the July meeting. Such a hawkish scenario was supported by Fed spokeswoman Mary Daly, who, however, does not have a vote in the Committee this year. Nevertheless, the hawkish rumors did their job: the EUR/USD pair again renewed the 20-year price low, plunging below the parity level, to the level of 0.9953. But as soon as other Fed officials (primarily those with voting rights) criticized the idea of a 100-point increase, the greenback weakened across the market. The dollar literally slipped out of the blue and allowed opponents to seize the initiative.

EUR/USD bulls may find themselves in a similar situation on Thursday. After all, now a 25-point increase in the rate is no longer the base scenario, but a “conditional dove” scenario, the implementation of which will put pressure on the euro. To strengthen the single currency, the ECB needs to either raise the rate by 50 points on Thursday or announce such a step in the context of the September meeting in plain text. Any doubts of the central bank will be interpreted against the euro.

Also on the ECB’s agenda is the issue of a possible uncontrolled expansion of spreads between the yields of government bonds of the EU core countries and the southern states of the bloc. Back in June, the ECB announced the development of a new tool to limit fragmentation in the eurozone. According to Bloomberg, at its July meeting, the central bank will present an unlimited bond buying tool that will help markets “adjust to sharper and faster interest rate hikes than previously thought.” However, if the representatives of the ECB show excessive caution in tightening monetary policy, this fundamental factor will be ignored by the market.

Thus, the single currency found itself in a kind of trap of inflated expectations ahead of the ECB meeting. In my opinion, it will be difficult for ECB members to realize the expected hawkish scenario, even despite a record increase in headline inflation. It is also necessary to take into account that the core consumer price index in the eurozone (excluding volatile energy and food prices) unexpectedly slowed down its growth on an annualized basis, reaching 3.7% instead of the planned growth of 3.9%. And German inflation last month showed the first signs of a slowdown. All these factors reduce the likelihood that the ECB will decide on a 50-point rate hike.

Consequently, EUR/USD bulls are forced to rely only on an unexpected “hawkish impulse” of the ECB. To put it bluntly, this is an unlikely scenario.

In anticipation of such important events of a fundamental nature, it is advisable to stay out of the market. Amid a general weakening of the US currency and a (possible) weakening of the euro, it is reasonable to wait for the results of the ECB’s July meeting: the pendulum will swing in one direction on Thursday, determining the further vector of movement for EUR/USD.

*The market analysis posted here is meant to increase your awareness, but not to give instructions to make a trade.

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