EURUSD downside potentially limited as dovish ECB widely expected

The fact that the EUR/USD has been unable to go up so far in the year, despite gains for the likes of the pound and commodity currencies against the US dollar, is a direct reflection of the troubles in Eurozone economy. As well as Brexit uncertainty undermining confidence, a slew weak economic data in the Eurozone has dampened rate hike expectations from the European Central Bank. The market is clearly expecting the ECB staff to lower their projections on GDP and inflation. But as my colleague Matt Simpson pointed out earlier, if the ECB refuses to provide weaker forecasts than some expected, then this could actually send the euro broadly higher.

Economists at the ECB probably view the ongoing weakness as being imported from external demand, due, for example, to US-China trade tensions and Brexit. They, like many other central banks, probably expect these factors to fade and the economy to grow faster again in the years ahead. In December, the ECB downgraded its 2019 GDP outlook to 1.7% from 1.8% it had projected in September but decided to keep the 2020 outlook unchanged at 1.7%. The central bank is likely to downgrade both forecasts today, potentially to around 1.5% for 2019 and 1.6% for 2020. However, these figures might be priced in, so the euro might not weaken considerably if this turns out to be the case. Any projections above these figures will likely provide a boost to the euro.

The other talking point among market participants is about long-term loans known as TLTROs or targeted longer-term refinancing operations. The ECB is widely expected to give lenders these long-term loans to keep credit flowing to companies within the single currency bloc.

So, it is possible that the euro, in a knee-jerk reaction, will initially drop. But with the markets likely to be already expecting a dovish ECB, the downside could be limited. Indeed, we could potentially see a reversal in the downward trend today in the event the ECB is not as dovish as the market expects.

The EUR/USD will also be impacted by events on the other side of Atlantic. Friday’s US jobs report, for example, could move the dollar sharply in one or the other direction. So, any ECB-related move in the EUR/USD exchange rate could be short-lived given the potential for profit-taking ahead of Friday’s jobs report. Indeed, one other reason why we are half-expecting the EUR/USD to bounce is because of the ongoing divergence in the exchange rate and the yield spread between German and US 10-year bonds. Usually, the EUR/USD and this bond yield spread go in the same general direction, but as can be seen, below, on the occasions where the EUR/USD has not stuck to script, it has eventually caught up or down with the spread. So, don’t be surprised if the EUR/USD creates bottom around the long-term 1.13 support handle in the coming days/weeks.