This week we get the much-anticipated ECB meeting. This comes at an interesting time for financial markets. The euro is sinking, EUR/USD fell 1.18% last week and is down more than 2.4% in the past month. Not even a hawkish Christine Lagarde at last month’s Jackson Hole conference has stopped the slide. Instead, concerns about Europe’s largest economy, Germany, which has seen industrial production fall sharply in recent months, along with concerns about China, a key export destination for the currency bloc, has weighed on the currency. Last week, the euro ended an eighth straight week of losses vs. the dollar, this week, Christine Lagarde, and the rest of the ECB’s governing committee holds the fate of the euro in their hands.
One final hike?
The problem for the euro is interest rate differentials. Even though the Federal Reserve is expected to hold rates steady later this month, and the ECB is expected to squeeze in another hike when it meets on Thursday next week, the interest rate differential between German and US 1-year yields is 1.82%. Since yield differentials are a key driver of currencies right now it is hard to see how the euro can claw back recent losses. Compared to the Eurozone, where economic data is surprising on the downside, in the US economic data has surpassed expectations and suggests that the US economy is in good health as we move through Q3. The Citi economic surprise index for the Eurozone is deep in negative territory, in contrast, the Citi economic surprise index for the US has been trending higher in recent months and is currently at +60. Thus, analysts have had to upgrade their US economic forecasts at the same time as downgrading their Eurozone economic forecasts, which is having a currency impact.
A close outcome
Rate hikes in the past 12 months and plunging economic confidence in the currency bloc, favour a pause in the ECB’s rate hiking cycle. At the July meeting, Christine Lagarde seemed to suggest that the chance of a hike in September was in the balance, however, her comments since then have veered more to the hawkish side. Even so, the recent decline in the economic data, which is now weighing on consumer confidence, suggests that the outcome of Thursday’s meeting will be a close one, with robust debate. Thus, the volatility in EUR/USD could be heightened as we lead up to this meeting, and we expect a violent reaction to the decision, after EUR/USD fell below the $1.07 level at the end of last week. A pause and dovish commentary could send the euro lower on a broad basis, and for EUR/USD we could see an even sharper decline, with $1.05 a possibility, especially if Wednesday’s US CPI for August is stronger than expected.
The ECB to set the tone for the major central banks
Right now, we think that the ECB will choose to hike rates before clearly signalling a pause is coming. A dovish hike could also weigh on the euro and would be good news for Eurozone stock markets. Could it also set the tone for other central banks? Threats to the global economy are growing, not least the rising oil price, with Brent crude oil breaching the $90 per barrel mark at the end of last week, which is a 20% jump in price since July. Since the ECB is the first out of the blocks post the Jackson Hole conference, they could set the tone for the BOE in the coming weeks, and maybe even the Fed, if they see the threat of higher oil prices weighing on consumer demand. While inflation remains a threat, and one that central banks around the world will be watching closely, aside from oil prices, the disinflationary trend is continuing. For example, food selling prices are lower even if consumer inflation expectations have trended slightly higher this summer. Thus, one final hike from the ECB and then a prolonged pause is our expectation for this meeting, even if we think that the ECB and other central banks will be loath to communicate a willingness to cut rates at this stage.
US inflation – it’s all about core
Elsewhere, as mentioned, the US CPI report will also be watched closely. We continue to think that the Fed will pause when they meet on 20th September, however its inflation report is also expected to show a steep rise in headline inflation, with the MoM rate for August expected to expand by 0.5%, vs a 0.2% rise in July. The core rate of CPI is expected to remain at 0.2%. If core price growth in the US remains stable, even if headline moves higher, this strengthens the hand of the Fed to keep rates on pause for the rest of this year.
The BOE’s next steps could also be decided this week, with the latest labour market data released on Tuesday. The 3 MoM unemployment rate for July is expected to edge up to 4.3% from 4.2%, while the key wage data is expected to show average earnings ex-bonus for the 3-months to July at 7.6% from 7.8%. This is still high, however, as we have mentioned, the lowest paid could still be seeing large wage losses, but high and middle earners could have stable earnings, so the average seems higher. Thus, the BOE will need to be careful when using average wage growth to set policy, as higher interest rates are likely to hurt the lowest earners the most, and they could also be suffering wage declines, even if it doesn’t show through in the data. UK GDP for July is also worth watching on Wednesday, and it could tell us if growth in Q3 started on a negative note after a weak set of PMI data in recent months.
It’s also worth keeping an eye on China and the Apple share price. It fell 6% last week after Beijing banned the use of iPhones for some government workers. The risk is that the ban will be put in place more broadly in future. The market is not ready to buy Apple yet, and in the pre-market, Apple’s share price is only rising by 0.3%. Thus, there is some concern in the market that Apple could be in Beijing’s sights, and if we see more interference then its share price could fall further.