ECB Meeting, a turning point for the Euro?

Before the Federal Reserve takes a step, the ECB is likely to take another step.

According to the pricing of interest rate futures in the recent market, the probability of the ECB cutting interest rates at the September 12 meeting has reached 96.8%. It is widely expected in the market that the ECB will cut interest rates by 25 basis points at the September meeting, with the deposit facility rate dropping from 3.75% to 3.50%. The expected number of rate cuts within the year is 2.5 times, totaling 62 basis points.

Figure 1 ECB Interest Rate Cut Expectations

From three perspectives, the conditions for the ECB to cut interest rates again are already very sufficient. Firstly, economic expectations are further deteriorating. The Eurozone's GDP growth in the second quarter was lower than expected, with risks of recession in Germany; except for France's services PMI benefiting significantly from the Olympics, the manufacturing PMI in Germany and France remains below the expansion-contraction threshold.

Figure 2 Poor European Fundamentals

Secondly, inflation is steadily falling. Eurozone HICP inflation has fallen close to the ECB's target range, progressing more smoothly than in the United States.

Figure 3 European Inflation Decline

Thirdly, ECB officials have reached a high degree of consensus on the interest rate cut.

Table 1 ECB Officials' Policy Attitudes

The September meeting seems to be a foregone conclusion.

Meeting Highlights

Aside from the almost fully priced in 1 rate cut, where is the market's focus?

1. Forward Guidance

The author expects the ECB to maintain a data-dependent and gradual decision-making approach at subsequent meetings, without providing a specific preset interest rate path. The reason is that, on one hand, there is still significant uncertainty in European economic data, and in the second half of the year, there may be significant political risks in both the United States and other global regions, making it easy to fall into passivity by proposing a too clear interest rate path. On the other hand, there may still be disagreements within the ECB on subsequent policy decisions, and it is highly probable that a consensus on how to provide forward guidance has not been reached 2. Press Conference

The market is highly focused on Lagarde's press conference after the meeting, where they may look for clues about a rate cut in October. Currently, the market estimates a 50% chance of another rate cut in October.

3. Macroeconomic Forecast

During this meeting, the ECB will update its macroeconomic forecasts (there will be no economic forecasts in October, the next update will be in December). Considering that GDP growth in the second quarter of 2024 is already below their forecast from June, and energy prices are lower than the levels in June when the macroeconomic forecasts were made, the market is keen to see if the ECB will revise down the GDP growth forecasts for 2024 and beyond, as well as the forecasts for future HICP and core HICP levels.

A Turning Point for the Euro?

So, the question arises: could the Euro be at a turning point?

Although the market generally believes that the ECB's rate cut expectations are already largely reflected in the current exchange rate of the Euro, the author still believes that the Euro's risks are skewed to the downside.

Firstly, it is undeniable that the Eurozone economy lags significantly behind the United States and the United Kingdom. This meeting may still surprise with unexpectedly dovish policy signals. The ECB's forward guidance or policy signals could be even more dovish than market expectations, potentially causing significant fluctuations in the Euro.

Chart 4: Citi Economic Surprise Index

Note: Eurozone (purple) lags behind the United States (orange) and the United Kingdom (green).

Secondly, the recent strength of the Euro is mainly due to the weakness of the US Dollar. The market is currently pricing in nearly 5 rate cuts by the Federal Reserve this year, while rate cut expectations for the ECB are far behind, with a gap of almost two cuts. Historically, the ECB has been a follower of the Fed's policy. Even though the ECB has emphasized policy independence, it is hard to imagine the Fed cutting rates 5 times while the ECB only cuts twice. Considering the Eurozone's relatively smooth inflation control and its weaker economy compared to the US (especially post-Olympics), the author believes there is still room for this pricing gap to narrow.

Table 2: G7 Central Banks Rate Cut Expectations

Thirdly, political risks in France still exist and may not be favorable for the Euro. France has just appointed the center-right-leaning Michel Barnier as Prime Minister to gain right-wing support, but this is only the first step in forming the government. After the government is formed, it still needs to pass a vote of confidence in the National Assembly to gain support, otherwise the government may need to be restructured (the National Assembly can initiate a vote of no confidence). Potential political risks could at any time become the last straw that breaks the Euro's back From a technical perspective, the current US Dollar Index is also approaching a key support level. If the US dollar holds at this support level, the next step is likely to see a rebound.

Chart 5: US Dollar Index approaching key support

Chart 6: Euro breaking below the 21-day moving average

The Euro has now broken below the 21-day moving average. Will this interest rate meeting be an opportunity?

Rubbing hands, eager to try.

Author: Chen Min, Source: Good Morning Market, Original Title: "ECB Meeting, a turning point for the Euro?"