European Central Bank Preview: ECB expected to keep interest rates on hold as Eurozone economy stalls

• The European Central Bank is likely to leave key interest rates on hold on Thursday.
• Lagarde could leave the door ajar for one more rate hike by year-end.
• The Euro braces for volatility on the ECB decision and Lagarde’s presser.

The European Central Bank (ECB) is widely expected to leave interest rates unchanged for the first time since early 2022, following the conclusion of its monetary policy meeting on Thursday. The Bank will publish its quarterly updated staff projections alongside, while ECB President Christine Lagarde’s press conference will follow at 12:45 GMT.

European Central Bank interest rate decision: What to know in markets on Thursday

• EUR/USD is holding recovery gains near 1.0750 as the US Dollar (USD) remains on the back foot following the mixed US Consumer Price Index (CPI) data. 
• The annual United States inflation gauge rose 3.7% in August, compared with a 3.6% rise expected. The CPI rose 0.6% in August, its biggest monthly gain of 2023 and matched the market estimates. The core CPI increased 0.3% and 4.3% respectively, against estimates for 0.2% and 4.3%. 
• US S&P 500 futures gain on the market optimism, as the US data cemented Federal Reserve (Fed) pause bets.  
• The benchmark 10-year US Treasury bond yield drops toward 3.21%.
• On Tuesday, the German ZEW Economic Sentiment improved to -11.4 in September. However, the index gauging current conditions hit a three-year low at -79.4. “Financial market experts are even more pessimistic about the current economic situation in Germany than they were in August 2023,” the ZEW Institute said.
• The ECB event will be decisive for the near-term direction of the EUR/USD pair, as the focus shifts toward next week’s Fed policy announcements.

ECB interest rates expectations and implications for EUR/USD

The European Central Bank (ECB) is at a crossroads. The bank is set to face the hardest decision since it began raising interest rates in July 2022 as it battles heightened risks of stagflation. Eurozone’s annual inflation stood at 5.3% in August, down sharply from the 10.6% recorded in October 2022. Core inflation, however, remains sticky above 5.0% when compared to the ECB’s 2.0% target.

The Gross Domestic Product (GDP) in the old continent expanded by a marginal 0.1% in the quarter to June when compared to the previous quarter. Further, the European Commission downgraded its economic growth projections for this year and the next one, citing that the German economy has slipped into a recession.

Against this backdrop, the central bank is likely to announce on Thursday at 12:15 GMT that it will keep interest rates steady, with the Deposit Rate at 3.75% and the main Refinancing operations lending rate at 4.25%.

Comments before this key meeting suggest that ECB policymakers are split on the upcoming policy decision. Governor of the National Bank of Slovakia Peter Kazimir said last week that his preferable option would be to raise the policy rate by 25 basis points (bps) at the policy meeting next week. President of the Dutch central bank Klaas Knot told Bloomberg that investors betting against an interest rate increase next week are possibly underestimating the likelihood of it happening.

Meanwhile, on the dovish side, Governor of the Bank of France Francois Villeroy de Galhau said, “our options are open at the next and the upcoming rate meetings,” adding that “we are near or very near the peak regarding interest rates.” Portugal’s central bank chief Mário Centeno said the risk of “doing too much” has become “material” as the outlook for the eurozone economy has deteriorated in recent weeks. Italian central bank Governor Ignazio Visco noted: “I believe we are near the level where we can stop raising rates.”

However, the market’s pricing for the ECB’s interest rate decision this week has changed dramatically after a Reuters report said on Tuesday that the ECB expects inflation in the 20-nation Eurozone to remain above 3.0% next year, bolstering the case for a tenth consecutive interest rate increase on Thursday.

Ahead of the report, there was only a 35% chance of the ECB raising its key rates by 25 bps on September 14, which is now seen as significantly higher at 63%, according to data from Reuters. The revival of the hawkish ECB expectations gave strength to the Euro, with the EUR/USD pair jumping back toward 1.0800.

If the ECB holds rates with a hawkish language, pointing to one more rate hike by year-end, EUR/USD is likely to resume its upswing toward 1.0850. A bullish reversal from multi-month lows will be confirmed should the ECB announce a 25 bps rate hike, although the policy guidance and President Christine Lagarde’s words will hold the key for the additional upside in EUR/USD. On the contrary, an ECB rate hike pause combined with a lack of clarity on the central bank’s path forward will cheer doves, pushing EUR/USD back toward 1.0650.

Dhwani Mehta, Asian Session Lead Analyst at FXStreet, offers a brief technical outlook for the major and explains: “EUR/USD is trading on the front foot ahead of the key ECB event. The 14-day Relative Strength Index (RSI), however, is holding below the 50 level, suggesting that upside attempts could be limited for Euro buyers.”

Outlining important technical levels to trade the EUR/USD pair, Dhwani notes: “On the upside, buyers need to take out a strong resistance at 1.0800, the confluence of the round level and the bearish 21-day Simple Moving Average (SMA), to extend the recovery toward the 200-day Simple Moving Average (SMA) at 1.0828. The next upside barrier is seen at the psychological level of 1.0850.”

“Alternatively, critical support is located at the three-month low of 1.0686. A sustained break below that level will challenge the May low of 1.0635, below which a fresh downswing toward 1.0600 cannot be ruled out.”