The ECB meeting in September will be a binary risk event for the euro. Our base case foresees a rate hike, which would translate into a stronger euro after the announcement, as market prices lean in favor of maintaining them. But as EUR/USD has been on a steady bearish trajectory since July’s 1.12 high, the real question is whether a rally would reverse the trend. The short answer is probably no, but there are some important considerations to make.
Firstly, it is worth explaining why we believe the currency impact of an ECB hike will be short-lived. A key reason is pricing: markets have doubted the ECB’s ability to raise rates this week (9 basis points discounted), but are still looking at a total of 17 basis points of adjustment to the maximum by the end of the year . Arguably, ECB hawks will not have much interest in implementing a hike this week and adopt a dovish tone, as effective adjustment through rates would be limited, so they should accompany a hike with openness to do more. However, with economic conditions in the eurozone rapidly deteriorating and moderate dissent growing within the ECB, it will be difficult to convince markets to price in any further adjustment.
When we look at the two-year swap rate spread between the euro and the dollar, an important driver of currency fluctuations, we can say that it has recently approached the support level of -125 bp (five central bank “lengths” between the Federal Reserve and ECB). Let us remember that the swap rate indicates the expected average rate for the next two years, so it includes expectations about the final movements of the adjustment cycle (if any) and rate cuts. What has really driven the recent widening of the differential in favor of the dollar has not been any upward reassessment in Fed rate hike expectations, but rather a reduction in bets on US easing for next year .