European Central Bank Preview: ECB expected to hold interest rates again

• The European Central Bank is set to keep key interest rates steady on Thursday for the second time in a row.
• Eurozone economic outlook has worsened since the last meeting; however, ECB’s Lagarde could try to push back against rate cut expectations.
• Euro is likely to react to updated macro forecasts and Lagarde’s presser.

At the October meeting, the European Central Bank (ECB) kept interest rates unchanged after an unprecedented 450 basis points increase in rates within less than two years. On Thursday, December 14 at 13:15 GMT, the central bank will announce its decision, followed by President Christine Lagarde's press conference at 13:45 GMT. The ECB will also publish updated staff macroeconomic projections. The ECB is widely expected to keep interest rates unchanged. Markets consider that the tightening cycle is over, and rate cuts are expected for the first half of the upcoming year.

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

• Federal Reserve officials forecast three interest-rate cuts next year.
• EUR/USD jumped to 1.0900 following the FOMC meeting, as the US Dollar and Treasury yields tumbled. 
• The benchmark 10-year US Treasury bond yield tumbled to 4% on Fed’s policy pivot. 
• US S&P 500 rose sharply, breaking above 4,700 to the highest in almost two year; Dow Jones posts record close.
• Industrial Production in the Eurozone contracted 0.7% in October, worse than the 0.3% decline expected. Compared to a year ago, production was 6.6% lower.
• On Friday, the December HCOB's flash Eurozone Composite Purchasing Managers' Index (PMI) will be released with a modest improvement from 47.6 to 48 expected. 
• The ECB event could provide a fresh directional impetus to the EUR/USD pair, with attention set on expectations for what the central bank might do in the first quarter of 2024.

What is expected from the next ECB meeting and how will it impact EUR/USD?

Economists are widely expecting the European Central Bank to announce another hold on Thursday, keeping the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility unchanged at 4.50%, 4.75% and 4.00% respectively. After the policy pivot by the Federal Reserve at the December FOMC meeting, will the ECB definitively turn dovish?

Since the October meeting, inflation in the Eurozone has further softened. The Harmonized Index of Consumer Prices (HICP) experienced a 0.5% drop in November, and the annual rate stood at 2.4%, the lowest level since July 2021. The core inflation rate, which excludes volatile energy and food prices, slowed to 3.6%, the lowest since April 2022. Regarding economic activity, Gross Domestic Product practically stagnated during the third quarter, and reports from the current quarter indicate no significant improvement. The latest report before the meeting showed a decline in Industrial Production by 0.7% in October.

The combination of softer inflation and a weak economic outlook suggests that the ECB is unlikely to tighten monetary policy further at the last meeting of the year. Market expectations for rate cuts in the next year have increased, with a rate cut by the April 2024 meeting already priced in. “President Lagarde will most likely use her press conference to try to push back against the dovish narrative.  However, we note that her October conference was quite downbeat, and the growth outlook has gotten worse since then,” explained analysts at BBH. 

Discussions at the Governing Council are expected to focus on adjusting the Pandemic Emergency Purchase Programme (PEPP) and the Minimum Reserve Requirement, but analysts do not anticipate any decisions at this meeting. Another topic of debate is the reinvestment of proceeds of maturing securities.

The ECB is expected to maintain a cautious tone, refraining from declaring victory on inflation. Lagarde may reiterate the narrative of keeping interest rates “high for long” and emphasize that the market's pricing scenario is not the ECB's base case. Comments in a different direction could have significant market implications, with a dovish tone potentially triggering a sharp decline in the Euro.

The ECB will release staff macroeconomic projections for the Eurozone. Inflation and growth forecasts are expected to be revised downward. However, the revisions are likely to be moderate, as more significant revisions would require a change in Lagarde's narrative and could heighten market easing expectations.
“We look for a straightforward hold, with no other policy tweaks. Messaging should reflect recent ECB speeches, acknowledging constructive inflation dynamics and noting weak growth. Projections will be marked to market and are likely to show lower GDP and inflation forecasts,” summarized analysts at TD Securities, consistent with the views of most experts. If the ECB follows through as anticipated, the impact on the market could be relatively limited.

The EUR/USD pair peaked above 1.1000 in late November but experienced a subsequent bearish correction. It bottomed last week at 1.0724. After that, it moved sideways, until the FOMC meeting. The sharp decline of the US Dollar led to an upward movement in the pair, pushing it to 1.0900 and shifting the short-term bias to a bullish outlook. The next strong resistance stands at 1.0970, before the 1.1000 mark. The weak US Dollar serves as crucial support for the upside in EUR/USD ahead of the ECB decision.

On the flip side, the area around 1.0825 is a relevant technical support. The key level to watch is at 1.0730, represented by an upward trendline. If this level is breached and the price moves below it, it could potentially signal further losses and open the way for a downward trend to develop.

If the ECB keeps rates unchanged and Lagarde delivers no surprises, the impact on the market could be limited, and the focus will shift to the next meeting on January 15, 2024. In the unexpected scenario where the ECB strikes with a firm hawkish tone, potentially accompanied by an announcement of a reduction in the PEPP reinvestments, the Euro could rally, approaching 1.1000. However, it may not necessarily be sustainable, as it could swiftly fade as market attention turns back to the economic outlook.