Traders brace for euro's decisive moment at ECB's policy meeting

Foreign-exchange traders are bracing for one of the most pivotal meetings of the European Central Bank in years, where policy makers are set to pave the way for its first rate increase since 2011.

Options pricing suggests that traders haven’t been this jittery about an ECB rate decision since 2019. While the bank is widely expected to hold rates steady on Thursday, the question is whether ECB President Christine Lagarde will push back on expectations of 50-basis-point hikes in the future, which have been building over the past few weeks as the region’s record pace of inflation continues to accelerate.

The decision could be a game-changer for the euro. The common currency has been bogged down by concerns over euro-area growth and a resurgent dollar as the Federal Reserve embarks on a rapid hiking cycle. A decidedly hawkish pivot could help convince bears that policy makers are determined to tighten financial conditions despite the headwinds, lifting it further from a five-year low against the dollar touched last month.

The scale of any moves in the euro -- in either direction -- will “depend on the degree of urgency that will be presented by Lagarde,” said Ulrich Leuchtmann, head of currency strategy at Commerzbank.

“Anything that indicates 50-basis-point steps would be euro-positive, as there are enough market participants out there who are still skeptical about the ECB’s willingness to hike quickly,” he said.

Morgan Stanley strategists including Wanting Low recommend targeting the euro-dollar pair reaching 1.10 in the wake of the decision, a level not seen since early April, as ECB policy makers double down on hawkish rhetoric. BMO Capital Markets strategist Stephen Gallo assigns a 20% chance to a “very hawkish” scenario that would see the ECB raises rates at Thursday’s meeting, which could drive the euro-dollar pair close or “moderately above” that level.

In recent weeks, markets have moved to wager on about 140 basis points of rate hikes by year-end, and are betting on a 50-basis-point increase by September. Some Governing Council members have signaled openness to larger moves amid concern over the extent of inflationary pressures.

Comments over the possibility of a tool to contain spread-widening between core and peripheral eurozone bond yields have also given comfort that the ECB may be able to control fragmentation risk and keep hiking.

That’s tightened the yield differential between short-end US government bonds and their European counterparts, a key driver of the euro-dollar pair. By this metric alone, the euro should be trading closer to $1.09.

Still, any disappointment could only spell further weakness for the euro. People have been rebuilding long positions in the common currency, according to Rabobank FX strategist Jane Foley, which are vulnerable if policy makers push back on the market’s enthusiasm.

“Even if the ECB strongly signals the risk of a 25-basis-point move next month, this would unlikely produce any support for the euro,” she said. “I think a little more downside potential could be in store for EUR/USD over the next few days.”