The European Central Bank (ECB) is about to announce its monetary policy decision two days from now. More stimulus is already priced in, but the central bank may easily surprise financial markets. The big question is – will the ECB over-or under-deliver?
At this point, the EURUSD trades above 1.21 and keeps a bid tone. Naturally, the exchange rate is the last thing on the ECB’s mind, but still, it matters. If for some reason, the markets take tomorrow’s tone as hawkish, the Euro can easily squeeze higher. In that case, the risk is that the stronger exchange rate will become a problem further down the road.
How Can the ECB Surprise?
Thursday’s focus will be on the duration of the policy support measures. The ECB already let markets know that it does not favor a rate cut in December, and so the focus will be on the two elements it considers effective under the current crisis – the PEPP and the TLTROs.
One thing the ECB will do is to announce an extension of its PEPP (Pandemic Emergency Purchase Programme) – basically a quantitative easing program. Speculation on the market is that the program will be extended by June 2022. Should it choose to do so, the ECB must increase its size by a few hundred billion euros. The bigger the increase, the bigger the shock to the markets and the more dovish for the Euro.
Another way for the ECB to surprise the markets is to also increase the APP (Asset Purchase Program) – the traditional quantitative easing program. At this stage, the market is inclined to think that the ECB will wait until after its strategy review ends to decide on the APP. Should it choose to increase the APP in December, that will be hawkish.
Finally, the ECB is at risk of falling prey to its own strategy. It did nothing in October, preferring a wait-and-see approach, not knowing what the second wave of the pandemic will bring. Unfortunately, this translated into the financial markets building momentum ahead of Thursday’s decision. Therefore, markets may easily end up being disappointed even if the ECB will ease as it promised.
By not acting in October, the ECB also induced the wrong sentiment to market participants. If indeed, the EURUSD exchange rate is an issue, it had to act earlier.
Perhaps it is not?