Hawkish expectations rose significantly

The European Central Bank’s September meeting marked a small victory for the hawks, as the Governing Council decided to reduce the pace of asset purchases under the Pandemic Emergency Purchase Programme (PEPP), while keeping all other measures unchanged. Since then, a sharp rise in global energy prices has added upside risk to the inflation outlook, and a number of central banks, like the neighbouring Bank of England, have made quite a decisive hawkish shift in their language as a result.

The market reaction to higher energy prices has been channelled through a widespread hawkish re-repricing in rate expectations, which has also involved the ECB, as shown in the chart below. Markets are now pricing in a 10bp hike in the deposit rate in late 2022.

A neutral tone may lead to a (contained) EUR/USD correction

These hawkish expectations may face a first reality check at the October ECB meeting on Thursday. As discussed in our ECB Preview note, this week’s discussion in Frankfurt will likely centre around whether the recent upside pressure to prices will still prove more, or less transitory and crucially whether it will soon be necessary to further scale back the bank’s emergency policy tools. At the same time, recent comments by ECB chief economist Philip Lane suggest that the ECB is not really satisfied with current market expectations about the first rate hike.

Our view is that the policy statement and the following press conference by President Christine Lagarde will be quite neutral, possibly with a further more explicit acknowledgement that higher inflation could be more persistent in 2022. We think Lagarde will carefully try to avoid giving any hint that the current debate between the hawks and doves in the Governing Council is leaning in any clear direction, ultimately leaving many options open when it comes to the timing and pace of the unwinding of monetary stimulus. What we could see is the ECB bringing back Jean-Claude Trichet’s preferred phrase of ‘vigilance’ against inflation.

The clear intent to avoid giving details on tapering may disappoint the hawkish expectations currently priced into the short end of the EUR curve. From an FX perspective, we could see some euro weakness on Thursday as some of those hawkish bets are partly scaled back. Our short-term fair value model shows (chart above) that EUR/USD is currently trading in expensive territory (around 2.5% overvalued), with the short-term rate differential showing the highest beta of all factors considered in the model.

At the same time, a quick look at the recent EUR reaction to the latest ECB meetings suggests that the common currency has not been very reactive to rate announcements of late (chart below). Accordingly, we expect to see only a contained downward correction in EUR/USD on Thursday. The options market is currently pricing in around 35 pips of event-day volatility (measured as the break-even on a Thursday EUR/USD straddle).