Thursday, June 4, 2020

EUR/USD looks likely to drop on the ECB’s monetary policy decision today, but will it be only temporary?

  • Dollar
  • Euro
  • European Central Bank


Analysts’ Pick: EUR/USD looks likely to drop on the ECB’s monetary policy decision today, but will it be only temporary?

  • EUR/USD bears may benefit from a likely expansion to the ECB’s monetary policy today, although it might only be temporary
  • The current pace of purchases through its PEPP programme and increasing risk for an Italian sovereign debt crisis signals that the ECB is highly likely to expand monetary policy today
  • ECB President Christine Lagarde’s comments on expectations for the Euro area’s economic outlook supports monetary policy expansion as well
  • Downside risks for EUR/USD in the short-to-medium still remain limited as the European Commission continues to work on a finalised agreement between EU leaders on a stimulus package for heavily impacted European countries

The minutes from the ECB's last meeting signalled that the central bank is willing and likely to expand asset purchases at today's meeting, following the downgrades in forecasts for the Eurozone since the last expansion of its quantitative easing programs in March. With Lagarde stating that GDP for the Euro area is likely to contract somewhere between the ECB's medium and severe scenarios, i.e. between 8% and 12% for 2020, it is almost definite that today's monetary policy decision will be an expansionary one. Using the current pace of approximately 26 billion euros a week as an approximation of future purchasing pace, the PEPP will reach its 750-billion-euro limit around September or October this year. If the current pace of 26 billion is maintained throughout the year, the PEPP program will slightly exceed 1 trillion euros. This would mean imply that the PEPP is likely to expand by at least 250 billion euros, and that is assuming that the pace of purchases slow.

Extrapolation suggests that purchases of the PEPP program could potentially increase to more than 1 trillion euros


It is important to note that the central bank's emergency program has shifted away from its traditional use of capital keys to determine the proportion of debt to be held by the ECB. The central bank bought 37.4 billion euros worth of Italian debt since the start of the plan, which brought the proportion of Italian debt bought through the program to be greater than the relative size of Italy's economy and population to the Euro area. This is likely to continue as the ECB purchases Italian government debt to prevent surging yields as expectations for the Italian government to default on its debt increases.

The ECB is likely to be concerned with helping Italy avoid a debt crisis


The ECB is however, more likely to err on the side of caution and expand its asset purchase program by 500 billion instead to give itself more flexibility. This is even more likely as more sovereign debt is expected to be issued in the future with the European Commission proposing to add 750 billion euros using a combination of grants and loans for funding to help countries most affected by the Covid-19 pandemic.

The other aspect for today's ECB monetary policy meeting will be its economic outlook for the euro area. Lagarde is likely to reiterate her stance for additional fiscal stimulus from European countries and will likely welcome the European Commission's proposal for additional aid for heavily affected countries in the Euro area. Earlier this week, Australian and Canadian central banks were more optimistic for an economic recovery. But the ECB may differ from the two central banks as economic data for the EU has been mixed. Manufacturing PMI data for May was revised slightly downwards, while services PMI was revised upwards. Unemployment in Germany for May was higher-than-expected as well, signalling that companies may be recovering slower than expected even as lockdown restrictions in the country has starts to ease. Business expectations recovered in May but worse-than-expected current assessment surveys for businesses along with consumer confidence signals that consumer spending and business investment are likely to stay low for an extended period of time. A more pessimistic tone from the central bank should dent some optimism in investors' sentiment for the euro, which may temporarily put downward pressure on the currency.

Overnight index swaps implied probabilities suggests that the market is not pricing in any changes to the ECB’s key rates


While a 500-billion-euro expansion is likely to be priced in to the market, there is likely still room for the euro to face some downward pressure on the announcement of the decision, if there is additional pessimism on the Euro area's outlook. But this is likely to only be a temporary one, as risk sentiment across the world continues to fall. Initial and continuing jobless claims data in the US may provide additional downside for the greenback as well, with employment continuing to recover in the US. ADP's private employment report earlier this week suggests that smaller businesses were recovering faster-than-expected as compared to medium and larger firms. This could potentially imply that unemployment has more room to fall as smaller businesses starts to re-hire workers or slow lay-offs as the US continues to lax lockdown restrictions.

Smaller firms in the US unexpectedly saw a smaller decrease in net change in employment for May


Risks for the euro's downside will stem from increasing risk to the phase one trade agreement between the US and China, although incentives for both countries are unlikely to tilt in favour of backing out of the agreement at this point of time. A spike in Covid-19 infections may also increase demand for the dollar, but the risk of rising infections may be limited to the US as a result of the ongoing protests, which could potentially put less pressure on the euro as a result.

As a result, the ECB’s monetary policy decision today is likely to put downward pressure on the EUR/USD currency pair while short-to-medium-term downside risks for the EUR/USD remains relatively limited. Hence, EUR/USD may fall towards the support level of 1.1191's level and possibly break that before falling to 1.1165's level on the announcement of the ECB's monetary policy decision. But there may be some additional upside potential for the euro later in the trading session as jobless benefits data is set to release at 8.30pm (GMT +8), which could potentially push EUR/USD back higher towards 1.1258's level.

Technical Analysis:


EUR/USD has spiked over the past two weeks, rising much higher above the 200-day moving average, signalling a possible sell-off in the near future as a result of overvaluation. RSI has moved back below overbought levels, signalling that there may be more downside than upside potential in the medium-term. But while fundamentals tilt the outlook for the currency pair to the downside, the bulls may be able to continue to put upward pressure on EUR/USD as investor optimism continues to be fuelled by reports for an economic recovery. If today’s ECB decision pushes the currency pair past the 61.8% Fibonacci retracement level however, there may be an amplified fall as a result of profit taking, which could result in an additional drop towards 1.1138’s level. But downside risks for the euro still seems to be relatively limited in the short-to-medium-term as more fiscal stimulus is expected from the Eurozone in the near future.

Support: 1.1191 / 1.1165 / 1.1138

Resistance: 1.1258 / 1.1285 / 1.1342

EUR/USD Chart (H4)