Will ECB Drive EUR to 1.25?

After rising for 4 straight days, EUR/USD pared its gains ahead of Thursday’s European Central Bank monetary policy announcement.

The ECB is widely expected to leave monetary policy unchanged but among all of this week’s rate decisions, theirs should be the most market moving. Policymakers have been very clear that sometime this year, their guidance will change and the only question is how quickly they will start talking about unwinding Quantitative Easing and raising interest rates.

Although data has taken a turn for the worse since the last meeting, it is important to realize that many of these indicators are slowing from multi-month or year highs, which means they are retreating from very strong levels.

The Eurozone economy is still performing well, stocks are off their highs, Italy’s election may have led to a political stalemate but in Germany, Angela Merkel has won the right to form a coalition government with the Social Democrats, ending months of political uncertainty. The euro is strong but it hasn’t appreciated further than its end of January levels.

When the ECB last met, President Draghi acknowledged the euro’s rise by warning that euro volatility creates uncertainty but then spent the majority of his press conference talking about the solid and broad based momentum in the economy and the prospect of higher growth surprises that could lift core inflation over the medium term.

We don’t expect these views to change at this week’s meeting and given the market’s desire to sell U.S. dollars, ECB optimism could be drive EUR/USD back to 1.25. Yet if Draghi suddenly sounds more cautious, we could see a nasty reversal in EUR/USD as speculators are clearly leaning towards optimism