Euro Rebound at Risk from ECB's Sceptic Inflation Outlook

• EUR/USD rebounds from oversold levels
• Edging back above 1.1200 ahead of ECB
• Faces resistance between 1.1260 & 1.13
• ECB’s inflation scepticism may stifle EUR

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The Euro to Dollar rate recovered the 1.12 handle early in the new week but a nearby thicket of technical resistances on the charts and an impending European Central Bank (ECB) monetary policy decision could leave the single currency struggling to sustain its rebound later this week.

Europe’s single currency set itself on a tentative course for a hat-trick of gains over its U.S. counterpart on Tuesday in a continued bid to pare back losses sustained in the immediate aftermath of last Wednesday’s Federal Reserve (Fed) monetary policy decision.

The Euro-Dollar rate had fallen to an 18-month lows around 1.1120 after Fed Chairman Jerome Powell suggested that U.S. interest rates could be lifted in March and that they may rise faster and further than the market currently expects if inflation continues on its recent trajectory.

But with the Dollar cooling its heels early ahead of the weekend and early in the new week, the Euro-Dollar rate was able to rise back above 1.12 on Monday and appeared set to attempt a further recovery on Tuesday.

“A topside break of 1.12 would be the first sign to watch for a possible reversal in the EUR’s losses,” warned Juan Manuel Herrera, a strategist at Scotiabank, writing in a Monday research note.

Above: Euro-Dollar shown at hourly intervals with selected moving-averages and Fibonacci retracements of January decline indicating possible areas of technical resistance to a further recovery. Shown alongside U.S. Dollar Index. Click image for closer inspection.

• EUR/USD reference rates at publication:
  Spot: 1.1242
• High street bank rates (indicative band): 1.0844-1.0922
• Payment specialist rates (indicative band): 1.1136-1.1180
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“Markets may be emboldened by a 5% handle for German inflation to continue to bet on rate hikes this year. We think this is highly unlikely and the bank will continue to point to its expectation that inflation will slow to below target,” Herrera and colleagues also said.

While U.S. Dollar rates eased broadly early this week, likely explaining much of the uplift in EUR/USD, Monday’s preliminary inflation data from Germany may also have piqued interest in the Euro for its content and release in close proximity to this Thursday’s European Central Bank policy decision.

The Destatis figures showed the national measure of annual inflation edging lower from 5.3% to 4.9% but remaining close to its highest level since the early 1990s despite a dissipation of statistical base effects that had artificially inflated price pressures last year.

"We should think about these years of the pandemic, 2020, 2021 and 2022 as part of a pandemic cycle. In the first year 2020, inflation was relatively low. In the second half of 2021, inflation turned out to be quite high. And then, as we look into this year, 2022, we think inflation will remain high at the start of this year, but will fall later this year, especially towards the end of the year," said ECB chief economist Philip Lane, in a press interview.

Above: Market expectations for ECB’s -0.50% deposit interest rate. Source: Goldman Sachs.

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“We are clear from our December forecast that we expect inflation − in overall terms for this year − to be around 3.2 per cent in the euro area, and then to be below 2 per cent in 2023 and 2024. Compared with the peak, that's quite a big decline. We will see exactly the timing of how quickly inflation falls,” chief economist Lane told the Lithuanian business daily Verslo žinios on January 25.

It’s possible that part of the market viewed Monday’s German inflation figures as supporting the idea that this year could see the ECB further withdrawing some of the extraordinary stimulus provided to the Eurozone economy.

Pricing in interest rate markets has implied for some months that investors see the ECB as likely to begin lifting its deposit interest rate from -0.50% before the year is out, even though the ECB has repeatedly rebuffed such expectations, and this has potentially been supportive of the Euro.

“While the Council is likely to refrain from a significant re-assessment of the inflation outlook, we look for an acknowledgement that the recent rise in energy prices points to upside risk to inflation, which would open the door to upward revisions of the staff headline inflation projections at the March meeting,” says Soeren Radde, a senior economist at Goldman Sachs.

Above: Euro-Dollar shown at daily intervals with selected moving-averages indicating possible areas of technical resistance to a further recovery. Shown alongside U.S. Dollar Index. Click image for closer inspection.

"We believe that the requirement that underlying inflation be sufficiently close to target in order for the ECB to raise the Deposit Facility Rate is unlikely to be fulfilled in 2022. While a 2023 hike is possible if underlying inflation firms more than expected through this year, our baseline remains that the ECB will significantly lag other major central banks in monetary tightening," Radde and colleagues wrote in a research briefing last week.

The trouble for the market and potential rub for the Euro later this week is that even with overall inflation rates likely to remain elevated for some months yet, the ECB has so far remained confident that they will eventually fall and far enough to take the official consumer price index measure of inflation back beneath the bank’s 2% average target over the coming years.

The ECB may ultimately be among the last of the major central banks to become concerned if recent above-target inflation pressures persist for longer than currently envisaged given the difficulty European policymakers had in efforts to achieve sufficiently high inflation throughout much of the decade before the coronavirus crisis.

That difficulty was why the ECB turned to quantitative easing in January 2015 in a decision that later saw the bank develop a large footprint in the Eurozone government bond market.

This would also likely be at play if the ECB takes Thursday's policy announcement as an opportunity to reiterate its concerns about the medium-term inflation outlook and further rebuff suggestions that an interest rate rise may be seen in 2022.

“Recent developments support our forecast for EUR/USD to fall to 1.1000 in Q1,” says Lee Hardman, a currency analyst at MUFG. “The bearish EUR trend would be challenged though in the week ahead if the ECB does not push back as strongly against rate hike expectations for this year.”