ECB meeting preview: EUR breakout likely as Draghi considers rate cut

​This week sees the European Central Bank (ECB) come back into the fray, with the split expectations seen throughout markets pointing towards volatility whatever happens. With EUR/USD in consolidation mode over the past fortnight, there is a clear element of hesitation as markets await signal on where we go from here.

Firstly, we need to address the question of why the ECB finds itself in this situation. The past two months have seen market expectations of a rate cut jump significantly, where market pricing has gone from 1% in early June, to the 36% seen today. The chart below highlights a recent reversal in fortunes, with expectations drifting lower following the peak of 51% on Monday.

Why would the ECB cut rates?

There was a clear shift in expectations back in the middle of June, when ECB President, Mario Draghi, laid out a new dovish direction in the wake of a sharp decline in eurozone inflation. Draghi’s comments pointed towards the possibility of another round of quantitative easing should inflation not pick up. We have since seen the subsequent June consumer price index (CPI) figure tick higher to 1.3%, yet inflation remains woefully short of the 2% target set for the ECB.

Growth remains a huge issue for the ECB, with a German-led slowdown bringing about European Commission predictions of a 2019 growth rate of 1.2%. Meanwhile, Germany growth is expected to come in at a lowly 0.5%.

With growth and inflation both lower than desired, it is clear that the ECB may have to act before long. This week sees a whole host of purchasing managers index (PMI) surveys being released for the ECB, with the uncertain nature of markets bringing about a strong chance that expectations will shift significantly is those PMI figures heavily under or overperform.

Away from the economic side of things, there is also a chance that Mario Draghi will want to avoid a damaging EUR/USD rally. Despite Draghi’s insistence that the ECB does not seek to influence the forex markets, the impending rate cut from the Federal Reserve (Fed) points towards potential euro appreciation which comes to the detriment of eurozone exporters. Such a rise in the euro would also drive inflation lower still.

What measure would the ECB take?

The ECB have a number of tools at their disposal, with the previous use of tools such as interest rates, quantitative easing, targeted longer-term refinancing operations (TLTROs) and forward guidance providing market moves. However, for the most part we are not expecting much beyond a potential rate cut should the committee seek to make an early move this week. The next meeting takes place in September, allowing a more protracted period of planning for the committee to put together a more comprehensive easing package.

Where now for the euro?

Market direction will take its lead from the ECB and PMI surveys this week, with the current consolidation highlighting that willingness to wait for the answer rather before making a move. Coming off the back of a bullish June, EUR/USD is trading above a critical support zone around $1.1193-$1.1181. A break below that zone would complete a bearish head and shoulders formation, providing the first lower low in almost two months.

The recent consolidation seen for this pair points towards a ramp up in volatility when the breakout does occur. However, for now we remain within the $1.1193-$1.1286 range, which is likely to be respected until the key eurozone datapoints start hitting the markets. Watch out for the breakout from that range to bring about a directional breakout for the pair.