Markets brace for another ECB rate hike

What will the ECB do?

The European Central Bank (ECB) is expected to raise rates by 50bps at its meeting.

What is the background?

Like most major central banks, the ECB has been pushed into raising rates in order to combat high levels of inflation. While energy prices have come down, price increases remain above the ECB’s 2% target, and as a result, the bank still views it as necessary to push ahead. No ECB member has dissented from this view of late, leaving markets with little indication that a dovish caucus is forming.

Indeed, inflation remains high, but economic data remains resilient. Expectations for a recession, which were widespread as 2022 ended and 2023 began, have been pushed further out, towards the second half of this year and even into 2024, helped by a slump in energy costs that has allayed the worst fears of economists and investors.

What is the market impact?

If the ECB can send a suitably hawkish message along with the expected 50bps rate hike, then the euro may receive some support against the US dollar.

However, euro bulls must be aware that the pair has come a long way since the October lows, and while it only puts a modest dent in the 2022 downtrend, it does mean that the bar for further EUR/USD gains is rather high.

This is coupled with negative divergence on the daily MACD indicator, which suggests weakening bullish momentum in the short-term and a general unwillingness to push the rally much further in the near-term.

If the ECB is not viewed as being sufficiently hawkish, then EUR/USD may continue to weaken from its eight-month highs, but a move below $1.05 would be the minimum needed to indicate that the sellers have reasserted control.

Meanwhile in indices, a weaker euro could give the Dax some fresh impetus, but this would need to be fairly strong to counter worries about a weakening eurozone economy that might ensue. And if the ECB is much more hawkish and provides EUR/USD with a reason to recover then the risk to eurozone stocks is skewed to the downside.

Some might argue that, given the huge rally in the Dax this month, some weakness is needed to take the froth out of the index, which may well be pricing in too optimistic a scenario.

A drop back towards the 50-day SMA might bring the June and November 2022 highs into view as potential support. This would still leave the uptrend intact. Bulls would welcome further gains in order to cancel out the MACD’s negative divergence that looms large at present. Further upside targets 15,605 and then 15,725.