Should you buy the euro ahead of Thursday’s ECB Meeting?

One of the most interesting central bank meetings in 2022 is the European Central Bank (ECB) Meeting scheduled next week, on Thursday. The ECB is set to keep the main refinancing rate at zero, basically unchanged for many years.

But inflation is running much higher than the ECB’s target. The last CPI report showed that inflation reached 8.1% YoY in May, yet the interest rate is zero. Moreover, the deposit facility rate is in negative territory.

Are you looking for fast-news, hot-tips and market analysis?

Sign-up for the Invezz newsletter, today.

Is this the biggest disconnect in history between monetary policy and inflation? Perhaps it is.

The ECB, though, had a hard time setting the monetary policy. First, the global supply chain pressures remain elevated, even though COVID-19 restrictions are all gone in Europe and the developed world.

Second, the war in Ukraine, which began when Russia invaded its neighboring country at the end of February, led to a further leg up in the prices of goods and services. But because the war negatively impacted the economic recovery after the COVID-19 shock, the ECB hesitates in normalizing the policy.

Will the ECB raise the interest rates this upcoming Thursday? The market believes it will not, but this market cycle is different on so many levels that one cannot discard any outcome.

However, even if the ECB will not raise the rates, the common currency, the euro, is still bullish fundamentally, regardless of what the ECB does on Thursday. So here are the two scenarios for Thursday’s outcome, both leading to a hawkish outcome for the euro.

ECB  does not raise the interest rates in June

Let’s assume that the ECB will not raise the interest rates on Thursday. While dovish for the euro, the comments accompanying the decision will likely hint at a 50bp rate hike in July.

Hence, it could be a hawkish decision for the euro, despite the ECB not acting on rates.

ECB does raise the interest rate in June

Despite the vast majority of market participants discarding a move on rates next Thursday, one should not forget that the ECB is facing a historic decision. Never in the relatively short history of the common currency has inflation been so elevated as it is now.

For the central bank to delay hiking the rates, even by only six weeks, might be detrimental to consumer confidence and, ultimately, to its credibility.

Other central banks have already raised rates – multiple times. So why would the ECB be the last kid in town to do so?

Also, a surprise rate hike would put the euro back on a strong foot. But why would the ECB want to do so?

The answer lies in the common currency’s status. Suppose the euro keeps falling, as it did, and inflation keeps rising.

In that case, the common currency will start looking like an emerging currency – something the ECB is keen to avoid, given the fact that the euro is the second world reserve currency after the US dollar.

Raising the rates would push the euro exchange rates higher.

ECB’s credibility is at stake

It is worth taking some more about the ECB’s credibility. This is the first real inflation test since Euro area members adopted the common currency.

Credibility is key to central banks willing to be taken seriously by the population. This is a chance for the ECB to gain control of the inflation narrative, even at the risk of surprising financial markets.

Hence, a rate hike and even more hawkish rhetoric, should not be a surprise in June.

Will the ECB deliver? Regardless of raising the rates or not, the euro is in a good position for a short squeeze.