Euro: Although ECB Is Expected To Rise Interest Rate By 25bps, 50bps Move Wouldn't Be That Shocking

Euro: Although ECB Is Expected To Rise Interest Rate By 25bps, 50bps Move Wouldn't Be That Shocking
  • The ECB has pre-committed to raising rates by 25 bps in its July meeting.
  • A 50 bps rate increase by the ECB would not come as a surprise.
  • The bank’s rate hike guidance and new anti-fragmentation tool are being eyed.

Almost a decade ago, Mario Draghi pledged to do ‘whatever it takes’ to save the euro. Ten years later, the situation is no different and the shared currency is in a dire state yet again. Will European Central Bank (ECB) President Christine Lagarde repeat history by responding to a larger rate hike this Thursday?

The central bank meets on July 21 to announce the first interest rate hike in eleven years at 1215 GMT. Lagarde’s press conference will follow at 1245 GMT.

ECB could opt for a 50 bps rate hike

The ECB is on track to raise rates by 25 bps on Thursday, lifting the key deposit rate to -0.25%. A recent story by Reuters suggested that the ECB policymakers are set to discuss a 50 bps rate hike at the meeting. Therefore, a double-dose rate increase to control record-high inflation will not come as a surprise.

Money markets are pricing in 40% odds on a half-point rate hike this week while wagering 97 bps of tightening by September after earlier baking in a one-percentage-point increase.

I believe that the ECB will deliver a 50 bps lift-off this month, in the wake of rampant inflation, resumption of the Russian gas supply and the fact that the ECB is way behind the curve. It’s also worth noting that front-loading rates now may allow the central bank some room to pause or go slower on rate hikes when a recession hits.

The euro area is battling a record-high inflation rate of 8.6% on an annualized basis, reported in June. Lagarde clearly mentioned in the press conference following the June policy meeting that the rate hike path will remain ‘data-dependent’. Meanwhile, the latest European Commission forecasts showed that inflation is seen at 4% in 2023, lower than the current rate but still double than the central bank’s target.

ECB Preview: Is the time ripe for a 50 bps rate hike? - 1

Source: FXStreet

But Lagarde did walk back on her words and later said there were "clearly conditions in which gradualism would not be appropriate". Despite the well-telegraphed talks of a 25 bps rate hike, the ECB could follow the US Federal Reserve’s (Fed) footsteps in turning against its pre-committed guidance.

With inflation control on top of its agenda, the ECB needs to move forward with bigger rate hikes, as it remains the main laggard in the global tightening bandwagon. Even the Swiss National Bank (SNB) surprised markets with a 50 bps rate rise in its last policy meeting. Meanwhile, the Fed is likely to hike rates by 75 bps next week, totaling 250 bps of increases so far.

The premise for a quarter-point rate rise could be also ebbing fears over an imminent recession in the bloc, especially after Russia announced on Tuesday that Russia's Nord Stream 1 pipeline will resume gas flows on schedule this week but at reduced levels. The Nord Stream 1 carries more than one-third of Russia's natural gas exports to Europe and it was critical for the pipeline to restart after it went offline for 10 days on July 11 for annual maintenance.

However, a big move this week could trigger a renewed explosion in the peripheral bond yields, already when the Italian bond yields are through the roof amid simmering political turmoil in the region. But the risk could be mitigated by the policymakers if they announce a new bond-buying scheme on Thursday. The new transmission protection mechanism will cap member countries' borrowing costs when they are deemed to be out of sync with economic reality.

Sources with knowledge of the matter said, “ECB policymakers home in on a deal to make new bond purchases conditional on next generation EU targets and fiscal rules.”

"These include the targets set by the Commission for securing money from the European Union Recovery and Resilience Facility as well as the Stability and Growth Pact, when it is reinstated next year after the pandemic break,” the sources added.

Trading EURUSD price with the ECB

EURUSD price is witnessing a classic short-squeeze in the lead-up to the ECB showdown after the euro succumbed below parity against the US dollar last week. The pair has recovered roughly 300 pips from a two-decade low of 0.9952 but the further upside remains at the mercy of Lagarde & Co.

EURUSD could resume its downtrend towards parity on ‘sell the fact’ trading should the central bank deliver the expected 25 bps rate hike.

A double-dose lift-off could restore the ECB’s credibility in fighting inflation, offering a temporary boost to the euro. The main currency pair could extend the short-squeeze towards the critical 1.0360-1.0370 supply zone, eyeing 1.0400 the figure.

The upside risks to EURUSD price could be limited if Lagarde fails to commit on big moves in the September meeting. Also, the lack of details on the new anti-fragmentation tool could leave EUR bulls in limbo once again.

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