Anyone wanting to know what the ECB will decide on Thursday should carefully read Draghi’s speech1 from 24 April in which the ECB president outlined the problems that the central bank could address. Our analysis of the various options suggests that the ECB is likely to keep its powder dry on Thursday. At most, it could suspend the liquidity absorbing SMP tender. It should hold to its medium-term inflation outlook – partly because it is likely to have a moderately positive view of the economic outlook and credit supply, on the basis of the latest data. At the same time, it should uphold market speculation of further measures by referring to the strength of the euro and the ECB projections due in June.
Market reactions: how high will the euro go? The greatest risk in our view is that the euro will continue to appreciate after the ECB’s decision because the market will view the central bank as too hesitant. Of course, ECB president Draghi will once again stress the central’s bank readiness to take further measures at the press conference, and uphold speculation by pointing to the projections forthcoming in June. That said, we doubt that this will be enough to prevent a further appreciation.
That said, whether and by how much the euro gains further depends on factors beyond the ECB’s control. Since euro zone inflation first surprised to the downside at the end of October, the path of the EUR-USD exchange rate can be explained quite reliably by the two-year real interest rate differential. A turnaround in interest rates in the USA could therefore significantly weaken the euro versus the dollar. We actually expect two-year US yields to rise above 1% by the end of the year, which would be their highest level since spring 2010. Should the turnaround in interest rates already be apparent this quarter, as we believe, the euro is only likely to briefly reach new peaks.
Commerzbank