– EUR reaction hinges on ECB inflation assessment; GBP vulnerable ahead of the BoE
The EUR continues to trade with a heavy tone even as there is little sign of distress in the Italian bond markets – Italy- Germany 10Y spread has tightened further to 320bps, while Spain’s 10Y yields trade near 5%. Under normal circumstances, EURUSD would have tracked peripheral spreads higher to 1.3200 (see chart). The fact that EURUSD has remained heavy points to a combination of a) dovish ECB expectations and a move to position on the short side ahead of today’s announcement and b) stronger ADP employment data supporting the market’s outlook for a relative US economic outperformance, which has been broadly positive for the USD. For the ECB meeting, our economists expect a 25bp refi rate cut to materialize at either of the next two meetings. Markets do not appear to be pricing in a move this week but there will be focus on the overall message, especially on the new staff projections and the ECB’s characterisation of risks to inflation. Last month, the ECB maintained that the risks to inflation were “broadly balanced”, but that assessment could be altered to reflect the updated economic projections thus supporting expectations of a rate cut. That said, we do not believe that the lowering of the refi rate would be detrimental for the EUR given that the eonia rate is already trading close to the deposit rate floor. A move to negative deposit rates and/or quantitative easing would arguably have a much larger negative impact on the EUR but the bar for such radical ECB action remains quite high in our view. Our overall EUR outlook thus remains constructive as long as peripheral bond market stress can remain contained. Meanwhile, GBPUSD remains vulnerable and look to break below 1.5000, with today’s BoE policy announcement likely a critical catalyst for sterling. The decision will be a close call – recent PMI data was an upward surprise in an otherwise disappointing flow of economic news. Given that three MPC members voted in favour of QE last month, we believe the majority will opt for a moderate GBP 25bn balance sheet expansion, which would put GBP under further pressure.
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BNP Paribas