British Pound vs. Euro Today: ECB's Message and Tone on Policy Key

© European Central Bank

The next leg of the Euro's journey will depend on any shift in language and the tone delivered at the European Central Bank who deliver their March policy update.

The Pound-to-Euro exchange rate is presently quoted at 1.12 and is therefore sitting towards the lower end of its longer-term range that has been in place since September 2017.

The exchange rate looks unwilling to fall below 1.11 while at the same time unable to break above 1.15; however of late we have noted that momentum is looking increasingly negative and the threat of a more sustained moved lower looks to be likely.

The near-term moves in the exchange rate could well be decided by the Euro side of the equation as Thursday, March 8 sees the European Central Bank give its latest policy decision.

No major change in policy is expected but the message and tone is crucial for foreign exchange markets.

The ECB pulls the levers of monetary policy in the Eurozone which influences liquidity, interest rates, and flow dynamics, all of which impact on the Euro.

The key change expected at Thursday's meeting is an already sign-posted move to change the language of the ECB's 'forward guidance' or statement of policy projection.

"With the ECB tomorrow set to continue to imply that gradual normalisation will continue, the tailwinds for the EUR remain," says Hans Redeker, an analyst with Morgan Stanley.

The ECB warned markets in December that it would be adjusting the language of its statement in "early 2018" to make it more appropriate to the evolving backdrop of firmer growth, so the March meeting is arguably its last opportunity to fulfil that promise.

The ECB's January meeting minutes showed that at that meeting some of the members of the governing council already wanted to change the language back in January but were overruled in the end - nevertheless investors took their dissent as a sign the 'ground' was being 'prepared' for a change in linguistics at the next meeting, this Thursday.

Disappointment could therefore certainly hurt the single-currency given expectations.

The current ECB message is that it stands ready to increase quantitative easing (QE) should the economy begin to deteriorate; a position referred to as its "easing bias", however, the expected change in language is that the easing bias will be dropped.

If it is not dropped we would expect markets to express disappointment by selling the Euro.

Such a move would be seen as the beginning of the end for quantitative easing, a monetary policy tool designed to keep borrowing costs artificially low and the Euro weak in order to help stimulate growth.

It was the introduction of quantitative easing that saw the Euro come under sustained pressure as the printing presses pumped vast sums of liquidity into the Eurozone economy which was then exported across the globe, putting downward pressure on the currency.

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The ECB has already reduced quantitative easing by half and plans to end it altogether, however, it has always remained deliberately vague and kept the door open to extending its duration; if this were to be repeated then we would expect the Euro to struggle.

Analysts at TD Securities ascribe a 75% that the outcome of today's meeting will lead to a drop in the value of the Euro. They ascribe a 65% probability that the ECB will not change the language of its future strategy, or 'forward guidance' as it is called in central bank lingo, despite saying it would "at the start of 2018" back in the December 2017 meeting.

If correct, this should help the Pound-to-Euro exchange rate claw its way back towards the middle of its longer-term range and the key fulcrum at 1.13 we believe.

The removal of the easing bias would represent a firmer commitment to ending QE and probably lead to a bounce in the Euro. "At today’s ECB meeting the most important signal we will be watching is that the overall path towards policy normalization remain intact. So long as this is the case, we would remain buyers of EUR/USD on dips. The flow “normalization” story has more to run," says George Saravelos, an analyst with Deutsche Bank.

FX strategist Viraj Patel at ING Bank N.V. sees risks tilted to the ECB adopting an altogether more 'hawkish' tone at the meeting - meaning one that is more aggressively optimistic about growth and therefore supportive of the Euro.

"The EUR also sees an ECB meeting on Thursday, where we look for some dissension in the ranks from the noisy hawks. There is a slight risk of the language being modestly shifted to slightly less accommodative, although the threat to do more QE will remain," says Patel.

UBS Economist Rienhard Cluse expects only minor changes to the ECB's 'script'.

"Although the accounts of the December and January meetings indicated that the "language pertaining to the monetary policy stance" could be revisited in early 2018, we do not expect the ECB to make significant changes to its communication next week," says the economist.

That said, Cluse does expect a change in language, which conforms to his calls for and an end to QE in September of this year and the first interest rate rise in July 2019.

"Mr. Draghi is likely to stress "patience and persistence" while reiterating that the ECB's focus will gradually shift from QE to interest rates (forward guidance)," says the economist.

He highlights the seeming paradox of the relatively aggressive market expectations for ECB hiking interest rates earlier than foretold with moribund actual inflation, which has reached a 14-month low.

"We see limited justification for more aggressive repricing of the ECB rate hikes beyond our forecasts at the current juncture," says Cluse.

BNY Mellon senior currency strategist Neil Mellor sees continued low inflation as "staying the ECB's hand" despite the rate of growth reaching the strongest it has been for a decade.

The assumption must be that the ECB would err on the side of caution and tolerate higher inflation rather than run the risk of removing stimulus too rapidly.

"As we have argued, an inflation overshoot must be Mr. Draghi’s preferred risk when growth has been bought at such cost," says BNY's Mellor.

New Macroeconomic Forecasts

Another focus for the Thursday meeting will be the ECB's updated macroeconomic forecasts.

UBS's Cluse expects the ECB to leave growth and inflation forecasts unchanged with a risk that inflation could be revised down.

UBS expect the ECB to maintain its growth forecast of 2.3% for 2018, 1.9% for 2019 and 1.7% for 2020 and also expect the inflation forecast to remain unchanged (1.4%, 1.5%, 1.7% for 2018-2020), but acknowledge downside risks.

The unexpected rise in the Euro since the beginning of the year poses downside risks to Euro-area inflation by making foreign imports cheaper, and this could be a factor in the lack of upside for inflation.

This has been suggested as posing a major challenge to the ECB and risking a delay in the expected change to the language of the statement discussed above.

The ECB is committed to pushing up inflation to its long-term target of just below 2.0% and this means there is clearly a risk it will fail in its promise to drop the easing bias since this will only exacerbate Euro strength and make it even harder to reach its inflation target.

Rising oil prices are one offset to the strengthening Euro's inflation dampening, as is the strong rate of growth in the region, highlighted by UBS.

For example, they show that high Eurozone PMI results in January and February - PMI's are a reliable survey-based leading indicator for the economy - already point to growth in Q1 of 2018 as likely beating expectations hands down.

According to the UBS GDP-PMI model, the average PMI observed in January/February (58.2, above the Q4 average of 57.2) suggests a Eurozone GDP growth rate of 0.8% q/q in Q1 2018, i.e. above the Q4 rate of 0.6%.

Italian Effect

Another factor in the ECB's balancing exercise may be the recent results from the Italian general election which saw a marked shift towards anti-EU parties.

These parties are less likely to implement the kinds of reforms the ECB have been encouraging ever since the crisis.

BNY Mellon's Mellor reminds us how ECB President Draghi has been warning member states how those which have not embraced reform sufficiently diligently may find themselves in trouble when the ECB removes its QE programme and borrowing costs start to rise again.

He says that the "biggest challenge for the ECB" may be "weaning the Italian government off its bond-buying programme."

There is a risk it may not just be low inflation which "stays the hand" on Thursday but also new risks to the more vulnerable Italian economy after Sunday's elections.

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