Will the EUR/USD Rebound or Keep Falling?

The meeting of the Governing Council, with its six members on the Executive Board and governors of the national central banks of the 19 euro area member countries, was held in the Netherlands on Thursday 9^th June, with a press conference held shortly after.

As the ECB tone was considered too dovish for market participants, the EUR/USD lost 0.90%, even though the ECB confirmed upcoming rate hikes and the start of its monetary policy normalization process. Investors are now wondering if the currency pair will keep falling toward its previous lows, or if it will bounce back…

Main takeaways from the ECB monetary policy and press conference

In the opening statement of yesterday’s Monetary Policy decisions, the European Central Bank (ECB) President of the Governing Council, Christine Lagarde, confidently vowed to have inflation back under control at 2% in the medium term.

As many expected, the ECB has held off raising interest rates for now, though a 25 basis point increase is expected in July (21^st), the first since 2011, and then again in September. The September increase will be dependent on the inflation outlook over the coming months, and if it fails to improve from May’s CPI of 8.1%, then an increase of up to 50 basis points may be considered.

After 8 years of negative rates, the ECB has also signaled an end to its stimulus scheme of net asset purchases (APP) on July 1^st, worth around 5 trillion euros since 2014, and an end to its quantitative easing program, closing the door on its loose monetary policy of previous years.

This is still well behind most of Europe’s peers on the world stage, including the US Federal Reserve, the Reserve Bank of Australia, the Reserve Bank of New Zealand, the Bank of Canada, and the Bank of England, all of which have been more aggressive in their monetary policies, while promising more rate increases to come.

With regards to the pandemic emergency purchase program (PEPP), the Governing Council asserted that it intended to reinvest the principal payments from maturing securities purchased until at least 2024, and that these reinvestments could be flexible across asset classes, jurisdictions, and time, stating “the portfolio will be managed to avoid interference with the appropriate monetary policy stance.”

Speaking at a press conference following the meeting, President Lagarde said of the rate increase: “Do we expect that the July interest rate hike will have an immediate impact on inflation? The answer is no,” she said “It is not just a step, it is a journey.”

The Governor continually advocated for flexibility and optionality during her speech and as she took questions, which may point to a lack of commitment to the idea of aggressive increases in the face of slowing economic growth, especially since it was only months ago that she suggested an increase in rates this year was highly unlikely.

With energy prices up nearly 40% from 12 months ago, and food prices up 7.5% in May alone, Lagarde commented that inflation was “a major challenge for us all” and that it had “broadened and intensified.” Eurosystem staff projections showed that the situation may only become worse from here, at least this year, as they have downgraded growth forecasts and upwardly revised inflation projections.

The Eurosystem’s projections about growth have been revised downwards to 2.8% for 2022 and 2.1% for 2023. However, projections for 2024 have been revised upwards to 2.3%. The revised projections for inflation state that by 2023 annual inflation is slated to drop from the 2022 projection of 6.8% down to 3.5%, and drop further to 2.1% by 2024 – which is still marginally above the ECB’s goal of 2%.

The ECB blamed the war in Ukraine and recent lockdowns in China for weighing down the economy, disrupting trade, and overall restricting growth in the short term. Lagarde suggested that the economy will pick up again though as a result of a strong labor market, fiscal support, and the world’s reopening post-pandemic.

What to expect for the EUR/USD pair

So the beginning of policy tightening has been set into motion, but investors are left guessing exactly where the ECB’s intended endpoint will be. Lagarde has pointed to rates needing to move towards the neutral point where the ECB is not simulating or holding back growth, but this level has yet to be clearly defined.

Questions also remain about what the ECB will do to combat the divergence in borrowing costs of member states such as Italy, Spain, and Greece, with yields on their government bonds rising far more quickly than other states like Germany and France, calling into question the one-size-fits-all monetary policy.

Markets are predicting 139 basis point rate increases by the close of 2022, which would mean an increase at every coming meeting from July, while also pricing in an anticipated 230 basis points of increases in the deposit rate by the close of 2023, which puts the interest rate peak near 2%.

The euro advanced slightly following the ECB’s announcements, but took a turn during the less-than-confident press conference with Lagarde. Because the interest rate differential between two countries is one of the leading factors influencing a currency pair price movement, many wonder if the EUR/USD is able to keep rising, as the Fed has adopted a more aggressive stance on its monetary policy than the ECB.

With the highly anticipated U.S. consumer price index report to be released today, volatility on the EUR/USD could be significantly higher today.