Investors await ECB monetary policy announcement

Thursday’s European Central Bank (ECB) monetary policy announcement is the most important event risk this week. The ECB is widely expected to ease monetary policy, making it one of the few central banks actively fighting economic impact COVID-19 with fresh stimulus. Normally the prospect of new easing should be negative for a currency but investors bid EUR/USD sharply higher last month and there’s serious risk of a post ECB announcement EUR rally.

When the central bank last met in late October, ECB President Lagarde said they are looking to recalibrate all instruments at their next policy meeting. She warned that a contraction can’t be ruled out for the fourth quarter and there’s “little doubt” that more stimulus is needed as they “will be looking at (recalibrating) everything.”

Analysts expect the ECB to raise its Pandemic Emergency Purchase Program by 400 to 600 billion and extend it to the end of 2021 and possibly even 2022. More asset purchases are likely as well but most economists are not looking for a rate cut.

Central banks consider a number of issues when deciding how to change monetary policy, but the most important are usually inflation, unemployment, growth and the exchange rate. Inflation is running at a year over year rate of -0.3% which is very low. Price pressures are starting to move higher with gas prices rising to their highest level since March.

In October, the ECB said risks are tilted to the downside but with the start of vaccine distribution, the outlook is brighter. There’s still a high degree of uncertainty, but recent data hasn’t been terrible – in fact there’s been more upside than downside surprises in Germany’s reports. The factory orders and industrial production rose more than expected. A brighter economic outlook from the central bank could drive the currency sharply higher.

However the strong currency is a big problem. Since ECB last policy meeting, EUR/USD appreciated as much as 3%. It rose from 1.17 to a high of 1.2175 before pulling back this week. The central bank admitted it was watching the EUR/USD rate back in October when it breached 1.19 and now they should be even more concerned as a stronger currency offsets easing. Will their concerns about the exchange rate be enough to offset optimistic comments? Probably not but given how much EUR/USD has run up over the past month, the pair is also begging for a correction.

The Bank of Canada (BoC) left monetary policy unchanged on Wednesday and pledged to keep rates on hold for the next few years. This decision was no surprise after a surge in new virus cases and nationwide lockdowns. Like many other central banks, BoC sees vaccine developments as “providing reassurance” but “until a vaccine is widely available,” it will be a “choppy trajectory.” USD/CAD found a near term bottom after the rate decision. While the BoC did not reveal anything new, the fact that they remain cautious was enough to drive USD/CAD higher. Given how far the pair has fallen, further short covering could take USD/CAD as high as 1.29.

GBP/USD traded as high as 1.3478 before giving up all of its gains to end the day virtually unchanged against the greenback. Prime Minister Johnson and EC President von der Leyen met in person today and we’re waiting to find out if any progress has been made on Brexit talks. GBP price action suggests that optimism is fading, but anything can happen.

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