Summary

• ECB Policy Meeting Thursday 10th September
• With inflation low and a stronger currency, what can the ECB do?
• What are the likely scenarios and how does the meeting fit into the overall macro picture?

Inflation
European central bank's (ECB) primary objective is to "maintain price stability". The ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) of "below but close to 2.00% over the medium term". HICP is core inflation.

Looking at euro area HICP over the last decade, the ECB has consistently missed their primary objective and in fact, core inflation has trended lower, testing zero before bouncing to 0.40%. And the overall inflation rate fell to below zero, into deflationary territory for the first time in four years.

Falling inflation is bad for an economy because if the cost of goods is falling, businesses and households may hold off spending to purchase at a cheaper price in the future. This in turn leads to lower demand for goods and services which slows growth, potentially leading to a recession.

Exchange rate
Exchange rate directly effects a country's economy. In a globalised world where goods and services are exported and imported, exchange rates play a huge role with a country's domestic inflation.

In a very simplistic way, the diagrams below illustrate the effect a stronger currency has on imports and exports. Imports
Country B imports USD 1mn of goods from country A. 6 months later the change rate strengthens 50% in favour of country B. The purchasing power of country B has now increased 50% is now able to buy USD 1.5mn of goods from country A for the same amount of euro's. This means country B's import prices has fallen (deflation). Which may lead to households and businesses delaying purchases now in favour of purchasing in the future at a lower price, slowing economic growth. A strengthening currency will cause downwards pressure on domestic inflation.

Exports
Country B exports EUR 1mn of goods to country A. 6 months later the exchange rate rises 50% and the purchasing power of country A decreases. On the global stage this makes country B's exports less attractive in relative terms if country C sells similar goods for a cheaper price. This may also slow inflation and economic growth as demand for exports may fall eventually hitting domestic businesses.

A strong currency can be a sign of a strong economy relative to others. The current macro landscape is that economies are still recovering from the post-covid recession, where growth, employment and inflation all fell sharply. Therefore, the main job for governments and central banks is to boost these three metrics.

A cheaper domestic currency facilitates growth in two main ways:

1) Import prices rise encouraging business and household demand, boosting inflation

2) Boosts demand for exports on the global stage. Therefore, post-recession it's best to have a weaker currency in relative terms

Since June, the EURUSD rate has risen more than 10% from 1.0800 used in the last inflation projections, this then means that in the September inflation projections (due on 10th Sept) will have to be revised lower for 2021, 2022. Which presents a problem for the ECB, how to boost inflation and prevent a further rise in the EURUSD?

What's driving eurusd?

• The coronavirus recovery fund is a structural change for the euro area allowing the block to raise capital on the global stage using Eurobonds. We've covered this subject in depth in previous articles, this should keep  EURUSD supported over the medium term.
  
  
• Ultraloose monetary policy from the Fed. During covid lockdown, a shortage of USD caused the greenback to skyrocket. In response the Fed opened SWAP facilities massively increasing the supply of USD's to calm the storm. Next the Fed implemented huge Quantitative Easing (QE), narrowing US yield spreads vs European peers meaning investors no longer had an advantage holding US assets, further weakening the USD.
  
  
• Finally, the Fed outmanoeuvred the ECB implementing Average Inflation Targeting (AIT) at its strategy review for the next decade after revising its approach to meet its mandate, which the fed admits failing to achieve over the last decade. The Fed also haven't implemented explicit forward guidance or needed to use any other tools. This ultra-dovish policy led the USD into a bear trend, US equities to rally sharply, Gold rallied sharply and real-yields reached record lows. 

Intervention
On September 1st, Phillip Lane verbally intervened when the EURUSD rate moved above 1.20. He said: "The euro-dollar exchange rate does matter"..."We don't have a specific target but EURUSD is important". This means the ECB are now openly watching the currency.

Historically, intervention only really works when the collective efforts of the G7 physically intervene in the markets. Examples being 1970's intervention in USD, 2011 intervention in USDJPY, and the Swiss National Banks multiple physical interventions with the Swiss Franc.

As stated by an analyst at the German financial services firm Allianz "Verbal intervention lasts a day or two, then the market gets back to focusing on policy" to which history completely agrees. So, if ECB President Lagarde follows through on lane's comments, we may see an initial dip lower, but asides from verbal intervention, what can the ECB actually do?

This leads me to believe that the ECB may be able to slow the EURUSD ascent and cause a retracement in the near term, but in the medium term the ECB won’t be willing to take major actions until higher up.

Remarks from ecb officials cement this view for me further:

• "Its a growing concern, though not yet huge, and if the trend continues it will be a concern and we will have to watch it" said an ECB member.
• "In the last few weeks there has been an appreciation of the euro, which is always worry-some when you have weak demand, especially as the euro area is the most open economy in the world and is unusually dependent on global demand". - ECB member.
• "The boost to global trade from a weaker dollar could offset a drag on eurozone exports from the strong euro. At the moment I’m not worrying too much about exchange rate developments". - Isabel Schnabel, ECB executive board member.
• "Euro's strength stemmed from positive factors such as the EU's recent EUR 750bn recovery fund and the eurozone's stronger than expected rebound from the coronavirus pandemic". ECB member.
• "We have to think about how we're going to see off an unnatural appreciation of the euro, there is no immediate need to act forcefully -- we are still awaiting signs of how the recovery is progressing".

This doesn't sound like consensus view that action must be taken to weaken the euro. And there is a mix of views as to whether the current rate is too high.

To me, this gives the green light that if the price was to break above 1.20 with conviction that the ECB aren't ready to do anything about it. It will of course be interesting to hear Lagarde's comments on Thursday.

Positioning
Remains close to record highs according to CFTC data. The bullishness creates a potential for a pullback towards the 1.18/17 area. "On that front, I’m not sure there's all that much the ECB can do to weaken the euro". Since the last report, EURUSD has fallen 2.00% which will show up in next week’s data.

The major trend is up for the euro and would expect dovish dip buyers to re-emerge at lower levels.

What can the ecb do?

PEPP

The bank could increase its Pandemic Emergency Purchase Programme (PEPP) purchases. PEPP is a form of Quantitative Easing (QE) launched in March 2020 to combat the effects of Covid-19. It's a temporary Asset Purchase Programme (APP) currently standing at EUR 1.35trl. The ECB may choose to increase it by EUR 350bn to combat tighter financial conditions, to boost inflation and attempt to weaken the EURUSD rate, a figure derived from a recent Bloomberg survey.

There is a risk this could happen at this weeks meeting, but the ECB may want to refrain from implementation to monitor incoming data and if inflation is still weak in December to implement policy changes at the end of year meeting.

One word of caution here, the reaction isn't as straight-forward as normal, as we're not in normal times. Usually QE is bearish for the currency as it increases the supply of currency and eases financial conditions. However, in June, once the ECB increased PEPP by EUR 600bn the currency rose! As PEPP boosted market-based inflation expectations! Will be interesting to watch how price reacts if ECB increases PEPP (low likelihood at this upcoming meeting)

DOVISH
The ECB could begin dropping hints about further easing during Thursday's meeting rather than actual implementation. Which would initially be perceived dovish but may leave EURUSD bears disappointed.

SURPRISE STIMULUS
Could see EUR 350bn in PEPP with mention of the possibility of a deposit rate cut in the future. This would be more bearish for EURUSD pushing the pair down towards the 1.1700 area of support.

KITCHEN SINK
ECB could go all in and implement EUR 500bn PEPP with a strong signal to cut rates in the near future. In this scenario EURUSD could fall below the 1.1700 area, coupled with major concerns over the inflation forecast.

DEPOSIT RATE CUT
Many analysts believe a rate cut is super unlikely but is a way the ECB could weaken the EURUSD rate.

Conclusion
In my opinion, the Fed have outmanoeuvred the ECB with their AIT framework review and realistically the only way the ECB can get level is to conduct their own strategic review which eventually leads to AIT in the euro area.

ECB strategic review isn't due to be published until next year! Until this is completed and implemented the USD will remain offered and the EURUSD strength is likely to continue medium term in my view. Even though positioning may cause a further correction to the downside in the near-term. Although I’d like to see price action confirm this thesis. Any major breaks of support with "kitchen sink" scenarios -- I’d be more open-minded to change my view.

If Lagarde talks down the euro on Thursday, may see a pop to the downside initially but price likely to find support and would expect buyers to re-emerge and for the uptrend to restart.

If Lagarde disappoints the market, i.e. isn't as dovish as everyone’s hoping, and the bar is pretty high, then the uptrend will likely continue right away.

If the ECB implement further PEPP without mentions of deposit rate cuts, unsure the reaction on price as it's not as clear cut as "QE is dovish and bearish for currency at the moment" as there is an argument for both sides.

If price hits the 1.1700/50 area and fails to break lower, I would look for the longs back up towards 1.20. If price rallies off the bat up towards 1.20 would also look for the longs in this scenario up towards 1.20. A breakout with conviction above 1.20 would be more bullish in the near-term.

A breakout below 1.1700 in the “kitchen sink” scenario may wash out shorts and rebalance positioning being more bearish in the near term and would re-assess the situation.