Credit Suisse

FX markets have been in consolidation mode over the past week, with the broad USD retracing lower after briefly trading above the March 2020 highs on 14 July.Hawkish Fed officials failing to push for a 100bp hike at the 27 Jul FOMC following strong June CPI data, and more aggressive tightening moves by ex US central banks appear to be the key drivers of the move, along with EUR’s inability to hold below parity. The pullback in the broad USD has already spurred questions on the durability of greenback strength, likely reinforced by recently stronger risk appetite. Our bias in favour of a stronger USD remains nevertheless intact, especially outside of G10, where the optics of an EMFX-led rally belie a still challenging picture.

Today’s ECB rate decision is the key event of the week. The already challenging task of reconciling rate hikes with stability in peripheral spreads was further complicated by calls for larger rate increases and by a fresh bout of political risk in Italy, which is set to culminate today in a make-or-break speech by PM Draghi. Markets seem largely positioned for PM Draghi to rescind his resignation. We think this limits the scope for EURUSD relief rallies on a benign outcome to the top end of our 0.97-1.04 target range and creates instead potential for a swift and messy return to below parity if political risk were to persist and become more entrenched. As for the ECB meeting, lopsided action addressing only one of the two policy priorities (hiking rates and containing spreads) is likely to be unhelpful for EUR. A sustained rally in EURUSD above 1.04 is in our view just not in the cards, as long as Europe faces ongoing energy supply challenges. We remain long a 12 Sep ’22 expiry 1.00 / 0.97 EURUSD put spread.

MUFG

EUR: Has the ECB had a last-minute change in thinking?

EUR/USD extended gains yesterday fuelled not just the broader sell-off of the dollar but also a sudden last-minute shift in expectations on the size of the rate hike expected to be delivered by the ECB. Firstly, the broader dollar sell-off was fuelled by the further recovery in risk assets. The S&P 500 2.8% gain yesterday took the key index to 7.3% above the closing low on 16th June. The improved appetite could well be a reflection of a view that bad news on Q2 earnings is already priced. As of last Friday according to Factset, only 7% of S&P 500 companies had reported and 60% had reported a positive EPS surprise – well below the 5yr average of 77%. The forward 12mth P/E ratio is currently 15.8, below both the 5yr average (18.6) and the 10yr average (17.0). Still, it is early days yet and this rally could well peter out if earnings results or guidance of bigger names was to disappoint – a scenario that seems a very plausible risk at this juncture.

ING

USD: Non-US events in focus

G10 FX volatility decreased significantly yesterday as markets started to take a wait-and-see approach ahead of today’s key risk event: the ECB policy announcement. Arguably, developments in the US are playing a secondary role this week, with markets mostly focused on European events (political, geopolitical and economic). Still, US housing data continued to show signs of weakness as mortgage rates rose. Given that this sector accounts for 2.5% of the US economy and that housing transactions have a high correlation with retail sales, expect recent grim housing numbers to further fan recession talk.

Meanwhile, the two drivers of dollar weakness earlier this week – risk sentiment recovery and the shrinking Fed policy advantage vs other central banks – have started to fade, and the dollar has entered some stabilisation mode ahead of major events in Europe today. The only data releases in the US today are the Philadelphia Fed Business Outlook and jobless claims, but expect very little market impact. As we expect the post-ECB reaction to trigger some EUR/USD weakness and given the other downside risks to the pair (Italian government collapse and curtailed Russian gas supply), we see room for some dollar rebound today. DXY could end the week in the 107-108 region.

Elsewhere, the Bank of Japan failed again to deliver any surprises at its rate announcement this morning. The policy message was a mere reiteration of the list of priorities for the BoJ: growth is more important than JPY weakness. With no support coming from a less dovish tone by the BoJ, risks of a move to 140+ in USD/JPY are non-negligible, especially if market sentiment stabilises and the Fed continues to put a floor under the dollar.

EUR: Three events, three downside risks?

It’s going to be a day like no other in the eurozone today, with three high-impact market events.

First, the European Central Bank will deliver its long-awaited first rate hike, and here’s our scenario analysis ahead of today’s decision. Our base case is the following: a 25bp rate hike today, openness to a 50bp move in September, only a slightly changed inflation and growth outlook (mounting downside risks should be highlighted for the latter), an anti-fragmentation tool without too many details and some degree of conditionality. It is therefore possible that the Bank will not shed light on whether a widening of sovereign spreads due to political events (like in Italy now) will be covered by the fragmentation tool. President Christine Lagarde will surely be asked about this, but may try to avoid giving a definitive answer.

The chances of a larger hike (50bp) appear to have risen after recent reports suggested this option was being seriously considered by the Governing Council. Markets are currently pricing in 38bp of tightening for today, and 200bp in total by March, which in our view is an overly hawkish expectation and may be revised lower today after the rate announcement. This leaves the euro vulnerable to some correction today in the event of 25bp, and may not receive very sustained support even in a 50bp scenario given the worsening macro picture.