It is a big day for the markets and in particular the EUR/USD with a monetary policy announcement from the ECB followed by the eagerly-anticipated US inflation report. But we should see other markets move sharply too today, including European and US stocks, as well as gold and other dollar pairs. The markets have been coiling over the past few days as traders didn’t want to take any bold positions ahead of the ECB meeting and US CPI. But we could see asset prices move more decidedly later this afternoon once the market decides to either play the existing “reflation trade” or perhaps the “inflation and tapering concerns” trade. I reckon it will be the former.
ECB likely to avoid taper talk
There had been some speculation that the ECB might start tapering its bond purchases as economic data improved markedly in the Eurozone, inflation heated up and Covid vaccinations sped up, with half of the adult population in the EU now having had the first shot of the vaccine. However, we have heard from several ECB members recently saying that the emergency policy measures will be needed for a while yet. What investors are hoping for is optimism from the ECB. The question is whether growth and inflation outlook are strong enough for the ECB to start talking taper. Recent data has disappointed, including factory orders, industrial production, retail sales and the ZEW survey, with the fall in expectations component of ZEW being particularly surprising given that major European economies are re-opening.
Stock market bulls should be kept happy
Therefore, the ECB may choose to avoid taper talk until the time when data shows the recovery is on a sustainable path. The ECB wouldn’t want to start the discussion prematurely, for this will probably send the euro surging higher, which in turn could hurt Eurozone exports. Indeed, the central bank is widely expected to leave interest rates and QE unchanged. This outcome, although expected, should keep the European equity markets happy.
The DAX, which was testing THIS key support area at the time of writing, could start a new bull trend if the ECB is indeed dovish, potentially rallying to a new record high soon:
Source: ThinkMarkets and TradingView.com
Will euro find renewed strength?
If there is any mild bullish twist, then that could be more positive development for the euro, although I doubt stocks would be spooked too much. The central bank could, for example, reduce its PEPP purchases, which is unlikely, or more likely change the language towards risks facing the economy as being “more balanced” as opposed to being “skewed to the downside.” It could also upgrade its economic forecasts, which could be seen as a hawkish signal for the single currency.
I feel like the euro could rise in any case. Even if the ECB is very dovish, the single currency may find support because this scenario could also trigger a “risk-on” response, sending equities higher. The EUR/USD has been correlating positively with the stock markets ever since March 2020. So, paradoxically, a dovish ECB may turn out to be a positive development for the euro.
However, if the dollar finds support across the board from the CPI report (see below), then the EUR/USD could drop regardless of the ECB.
US CPI inflation expected to rise to 4.2 percent
Just as the ECB press conference gets underway at 13:30 BST, all eyes will momentarily turn to US CPI inflation. CPI is expected to have climbed to 4.7% year-over-year in May, up from 4.2% previously, while core CPI is seen rising to 3.4% from 3.0% in April. On a month-over-month basis, CPI is seen rising 0.4% and core CPI is expected to print +0.5%.
Unless inflation comes in well ahead of expectations, the Fed’s stance will not change materially, meaning even if we get the expected figure of 4.2% for CPI equities could simply continue drifting higher until the FOMC’s meeting next week, with the dollar potentially weakening further. But if we see a bigger reading – like 5% or more – then inflation concerns could come back to haunt investors as this could raise speculation that price pressures are not going to be transitory. So, a lot depends on the outcome of the inflation report.
Inflation pressures are undoubtedly on the rise. But what matters is how the Federal Reserve interpret rising prices. So far, it has been very clear: inflation rising above the target is temporary. Indeed, with retail sales and non-farm payrolls disappointing, the Fed’s stance has arguably been justified.
EUR/USD coiling ahead of big events
With the trend being bullish, I wouldn’t bet against the EUR/USD still being on course to 1.25+ in the coming weeks. What the bulls would like to see now is a potential breakout from THIS triangle pattern: