Man proposes, but God disposes. The ECB probably didn't anticipate such a strong market reaction to the deposit rate hike to 4%! Instead of rising, the euro plummeted. The regional currency is poised to record its longest weekly losing streak since its inception. This is because investors interpreted Christine Lagarde's speech as a signal of the end of the monetary tightening cycle and started selling EUR/USD.
The ECB is dissatisfied, and for good reason. Not only did the euro fall, but there's also active discussion in the Forex market about a possible reduction in the deposit rate. Derivatives predict a sharp drop to 3.75% in 2024, 75 bps lower than the current level. Expectations of monetary expansion are driving down yields on European bonds, EUR/USD quotes, and weakening financial conditions. The ECB, on the other hand, needs tightening to effectively combat inflation. It's no wonder that Lagarde, both at the press conference and a day later, stated that discussions on the cost of borrowing at the September Governing Council meeting were not held.
Dynamics of market expectations for the ECB deposit rate
Market expectations regarding the ECB deposit rate dynamics are clearly linked to the ECB itself, which has reduced its GDP growth forecasts for the eurozone for 2023–2024. Despite the absence of a recession in these forecasts, the market doesn't believe the central bank. The belief in a relaxation of monetary policy is tied to expectations of a recession. Meanwhile, some banks predict that the first rate cut will happen as early as June.
The European regulator has fallen into the trap of stagflation, a combination of high prices and sluggish GDP growth. It considered it necessary to signal the end of the monetary tightening cycle and lost. The Federal Reserve will likely take note of its sad experience and prefer not to say that the current federal funds rate level is sufficient to bring inflation to the 2% target. If so, the decline in EUR/USD is at risk of continuing. Where could the bottom for the main currency pair be?
Forecasts of large banks on the ECB deposit rate
HSBC believes the euro will reach $1.02 by the end of 2023, and Capital Economics even talks about returning to parity. The divergence in economic growth, the significance of the American exceptionalism factor, and investor confidence in the end of the ECB's monetary tightening cycle all play a role.
For now, it's not clear what could trigger a correction in EUR/USD. The Fed won't weaken financial conditions with dovish rhetoric, and business activity in the eurozone is unlikely to significantly improve for a rebound. Perhaps the euro will draw strength from news from China, but it's too early to say that for now.
Technically, on the weekly EUR/USD chart, events are unfolding as expected. Before resuming its ascent, the pair needs to hit targets for the Three Indians pattern in the range of 1.0485–1.057. Prepare to take profits on previously formed shorts and switch to buying the euro from the convergence zone.