EUR/USD Forecast to Hit 1.10 if ECB Judged Too Timid

BMO Capital see a massive rally in the euro exchange rate complex if the ECB fails to deliver agressive cuts while other prominent analysts prefer to play the downside.

Barclays prefer selling the EURUSD at the start of a key week in global foreign exchange while BMO Capital warn that the prospect of a sharp relief rally have grown.

Expect Thursday’s ECB meeting to kick-start a volatile month for those with an interest in currency markets which are set to be dominated by central bank decision-making.

Thanks to ECB President Draghi’s repeated dovish comments the market has cultivated a negative bias towards the shared currency.

Recent comments by other ECB decision-makers, coupled with still unimpressive euro area inflation, have significantly raised market expectations, with EONIA forwards pricing more than a 10bp cut, assisting in the widening of EU/US real rate differentials and causing EURUSD to depreciate.

There is a word of warning though. Traders have actually become so aggressive and persistent in selling the euro against the US dollar over recent weeks that concerns have grown that the trade has become far too crowded.

Concerns on these crowded trades arise because when the market reverses direction it tends to do so with force and can often burn the fingers of those who had assumed the bet was a sure-thing. This has lead some to suggest the better risk-reward trade on the euro dollar exchange rate is now actually to the upside.

"If the ECB were to forego easing at this stage, EUR would stage a massive rally. We think it would immediately pop back up to at least 1.1000. All the market prepping has the ECB in a spot where it now has to ease. In fact, it appears that markets will need at least a ‘double ease’ to hold EURUSD where it is," says Greg Anderson at BMO Capital.

Anderson says the ECB has dug itself into a tricky spot as policy makers presumably wants to keep an arrow or two in its quiver in case more of a policy response is needed in the future.

Barclays See ECB Surprising to the Upside

Since the October ECB statement the market has been increasingly fixated by presumptions of a deposit rate cut of at least 10bp, this being set against an extension in ECB balance sheet, beyond the current September 2016 end date.

Recent ECB rhetoric has been unsurprisingly dovish, preparing markets for a fresh policy package.

“Given high market expectations, we see a risk that the ECB surprises to the upside; therefore, we remain short EURUSD,” say Barclays in agreement with those who suggest fears of a sharp squeeze higher may be overblown.

The prospect of a surprise - either to the upside or downside - remains elevated with up to 20 options said to be up for discussion.

Of note was talk of a potential two-tier system for charging deposits – a system that would be effective only if the ECB cuts the depo rate more than the market envisions.

Barclays do caution that even they do not believe a lower euro is a closed book trade saying given the increased expectations they see a risk for EURUSD to squeeze higher should the ECB disappoint.

“However, the ECB will likely not want to risk an unwinding of the recent rebound in inflation expectations and a squeeze higher in the EUR, which would ultimately tighten financial conditions through the rates and FX channels,” say Barclays.

If there is any move higher in EURUSD upside should the ECB disappointment by delivering what market expect, it will “likely be short-lived whereas the risks of more aggressive ECB easing is now higher, in our view,” say Barclays.

As such, the bank still favours being short EURUSD ahead of the meeting, preferably via options.

US Dollar Faces a Big Week

The euro to dollar exchange rate will again be at the forefront on Friday with the release of the US employment report which should should support market views of an imminent Fed rate hike and associated USD strength.

Markets are overwhelmingly expectant of a December interest rate rise, it goes without saying that should this not be delivered we are in for a sharp drop in the dollar exchange rate complex ahead of the new year.

If the employment data on Friday gives rise to such doubts then the USD could trade softer from that date into  December 16 at which point the Fed will deliver their decision.

Note too that the week ahead will be packed with Fed speak, as FOMC members Evans (Tuesday), Lockhart and Williams (Wednesday) will talk about the state of the US economy while Vice Chair Fischer will deliver a speech on financial stability (Thursday).

The market will pay particular attention to Chair Yellen’s testimony before Congress on Thursday, as it focuses on the economic outlook.