Hawkish ECB

The European Central Bank (ECB) had delivered a historically big rate hike of 75 basis points earlier in the month ^[1], bringing the Deposit Facility Rate to 0.75% and the highest level in more than 10 years.

According to policy makers, the decision "frontloads" the transition from highly accommodative rates and "will ensure the timely return" of inflation to the 2% medium-term target. Headline CPI Inflation hit new record highs of 9.1% year-over-year in Eurozone in August.

The move was accompanied by a hawkish policy statement, since officials noted that "over the next several meetings we expect to raise interest rates further", which had helped the Euro move way from parity against the greenback.

Hot US Inflation

European countries are not the only ones who are troubled by the high cost of living and the ECB is not the only central bank that acts based on high inflation. The US Federal Reserve has been on aggressive tightening path and its members have repeatedly stated that bringing inflation is their top priority, while dismissing recession fears after two consecutive quarters of GDP contraction.

US headline Consumer Price Index moderated to 8.3% y/y in August, but the Core reading that excludes energy and food prices, jumped 6.3% y/y to the highest level since March. This shattered hopes of peak inflation and bolstered expectations around the Fed's rate path, sending the US Dollar higher and Wall Street lower.

Fed Decision Time

At the past two meetings, the central bank had hiked rates by 75 basis point and has largely kept the door open to a similar move at this week's decision, due on Wednesday 21. Last week's CPI report has put an even larger, full percentage point move, in play. However, a 75 basis point increase has the highest probability (84%), according to CME's FedWatch Tool at the time of writing. ^[2].

Moreover, markets now see interest rates at 4.50% by the end of the year and as high as 4.75% in 2023. The Fed' June projections estimated the median rate at 3.4% by the end of 2022 and 3.8% by the end of the next year ^[3], which seemed reasonable at the time, but is far from where markets are now.

So we will be looking forward to Wednesday's updated Staff Economic Projections (SEP) for more insights as to where bank officials see rates in the near and medium term.

As always, the language of the policy statement and Chair Powell's press conference will be closely watched. The central bank has recently abandoned forward guidance and pivoted to a meeting-by-meeting approach, but we will still be looking at hints around the next step.

Furthermore, it will be interesting to see if there will be any mention to a "soft landing" - a reference that has been interestingly absent form Mr Powell's most recent remarks.

EUR/USD Analysis

The pair had strengthened in the aftermath of the ECB's hawkish decision, but the recent hot CPI report from the US sent it lower. EUR/USD hovers around parity at the beginning of the week, awaiting the Fed's decision for the next leg. Caution is needed, as such event can spark volatility and produce outsized moves.

The common currency had rejected the 38.2% Fibonacci of the May high/September low drop and the descending trendline from the 2022 lows, which creates risk of fresh twenty year lows below 0.9858. On the other hand, EUR/USD shows resilience around parity and may have the opportunity to push towards 1.2168, but a catalyst is required for such moves.