EUR/USD Powers Through in the Aftermath of the ECB’s Hawkish Action & Messaging

Outsized ECB Hike

The European Central Bank may have been late to begin tightening, compared to its major counterparts, but has moved pretty aggressively since then. After taking rates out of negative territory in July, officials delivered a historic increase of 75 basis points last week ^[1]. The Deposit Facility Rate now stands at 0.75% - the highest level in more than 10 years.

The outsized move was dictated by record inflation levels, which hit 9.1% in Eurozone in July, according to recent preliminary data. Policy makers judged that their decision "frontloads" the move from highly accommodative rates and "will ensure the timely return of inflation to our two per cent medium-term target".

More Tightening Ahead

The very hawkish accompanying policy statement pointed to more tightening in the following months, stating that "over the next several meetings we expect to raise interest rates further to dampen demand and guard against the risk of a persistent upward shift in inflation expectations".

Once again though, explicit forward guidance was absent, while President Lagarde refrained from assigning specific values to the neutral and terminal rate, during her press conference. She did however say that current level is "not the neutral rate" and that the bank is "far away from the goal" ^[2]

Reuters reported today that according to sources, policy makers could raise interest rates up to 2% or more in order bring inflation down ^[3], providing a glimpse into what the terminal rate ballpark may be.

Stagflationary Environment

Markets have underestimated the ECB's resolve to hike rates aggressively, as they fear a recession due to the energy crisis, which would make tightening harder. The central bank does not see a recession based on its updated baseline projections, but expects the economy "to stagnate later in the year and in the first quarter of 2023".

Its downside scenario however, does project a 0.9% contraction in the next year, in case of "more severe disruptions to European energy supplies" and other adverse events. ^[4]

Official upgraded their Inflation forecasts, now expecting it to stay above 9% for the rest of the year and average 8.1% (from 6.8% previously), before easing in 2023.

High inflation and economic slowdown mean stagflation and remains to be seen whether the ECB can maintain its commitment to raising rates, in this environment that pulls policy in opposite directions.

EUR/USD Analysis

The common currency had a mixed reaction on Thursday's decision, but the aggressive hike and hawkish commentary took hold, as the pair jumps today.

EUR/USD now tries to pierce into the daily Ichimoku Cloud and a break above this critical area (1.0200-16) could open the door to a bigger recovery to the August high and above (1.0369).

The pair is not out of the woods yet though, from both a technical prospective and a fundamental one, as the ECB is not the only hawkish bank. The Fed has been hiking rates since March and officials recently reiterated their commitment to monetary tightening, with markets expecting another outsized move next week.

The Relative Strength Index is overbought which could contain the Euro's rise. As such, we could see a return to parity, although new 20 year lows (0.9863) have a higher degree of difficulty at this stage.