Signs Mounting that Euro Hit a Ceiling

Don't expect too much going forward from the recent strengthening of the euro – problems in the eurozone keep piling up. The single currency is up nearly 2% since Aug. 20 as dovish signals from the Federal Reserve put pressure on the dollar. That said, with a European Central Bank policy decision day is already here, and a pandemic clouding the prospect of a hawkish move, the euro's gain could fizzle out.

If the European central bank surprises investors by cutting stimuli faster than they expect, the overall risk perception will expand again and impact the attitude towards the single European currency. According to the Washington Post, as much as the Fed has been doing in the recent months, the ECB could use the flexibility rhetoric into its pandemic support speech by trying to measure further pace of its bond purchases under the €1.85 trillion ($2.2 trillion) support program. Most likely, the ECB’s renowned director Christine Lagarde will opt to say the bank is not ready to phase out the purchases, and to caution that the economy still needs plenty of help as it heads into an uncertain winter with Delta cases rising in several countries and high commodities prices constraining employment outlook.

Signs are mounting that the euro is hitting a ceiling. This week, the BTP-Bund (10Y Italy’s Sovereign bonds vs. Deutsche Bund) spread narrowed to about 100 basis points from almost 120 in May. According to the average forecast of 84 analysts, the euro / dollar pair will remain virtually unchanged by the end of the year and will purchase $1.19.

However, the euro may temporarily test $1.20 this week – or whatever the expected highest mark for this year might be since late June, but it may require more surprise from the ECB than many now expect. This surprise will allow the main currency pair to break out of the current trading range. So far, the ECB has insisted that any rise in consumer prices is assumed to be temporary, i.e. purely the reopening-driven. This contrasts with the announcement of their counterparts such as the Federal Reserve, which noted the need to start talking about a cut in QE.

The currency is likely to go higher if the ECB announces a cut in monthly asset purchases, but this is unlikely to last long. However, ECB Director and Governor of the Austrian National Bank (OeNB) Robert Holzmann gave a strong signal to the markets that the “unexpected ECB decision should not catch them off guard”. Hmmm, something reminiscent of Putin’s “red lines”, isn’t it? According to his article for Eurofi magazine, the European Central Bank may tighten policy sooner than many now expect as inflationary pressures may prove to be more resilient. Let’s see… the clock is ticking down.