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The European Central Bank is set to decide on monetary policy on Thursday. Until just a few days ago, the market was fully confident that the central bank would hike interest rates by 50 basis points. After all, that’s precisely what the ECB President Christine Lagarde and several other members had strongly hinted at. But things have changed dramatically in the last few days. However, will that be enough to discourage the ECB from hiking by 50 bps?

Markets reprice ECB hikes rates lower

With the bond market in a bit of turmoil due to the fallout after SVB’s denouement, investors are now expecting only a 25-bps increase at the conclusion of Thursday’s meeting. They assess the likelihood of a 0.5% increase lower than a coin-flip. In terms of terminal rates, they now see the benchmark deposit rate peaking at 3.40%, which would be some 80 basis points lower than just a week ago.

Will SVB’s collapse discourage the hawks?

The recent developments regarding SVB definitely warrants a discussion over a 25bp hike. Some of the doves at the ECB’s ranks would undoubtedly argue that more caution is warranted. However, it is likely that the hawkish members of the governing council, including the ECB President Lagarde, will argue that the risk of contagion is low and that the US government’s swift actions over the weekend means that there is reduced likelihood of more small banks failing. The latter group would not want the ECB to fall further behind the fight against inflation, which, many would agree, they are already losing. It was only last week that Lagarde said that a 50 basis-point hike was “very, very likely.” She added that “I can’t think of scenarios, unless they were quite extreme, where that would not happen.” Does the SVB’s collapse, a small-sized American bank, fall under that scenario?

What do we expect the ECB will do?

While some of the hawks at the ECB’s Governing Council would no doubt continue to push for an aggressive hike, due to high inflation, the doves are likely to provide stiff opposition in light of the collapse of two US banks, which has raised the risks of financial stability. That said, we believe that the risks still remain skewed towards a 50-basis point hike. We believe that stronger-than-expected inflation data is likely to outweigh concerns over financial stability, potentially leading the ECB to disappoint the market’s substantial re-pricing of policy rates.

High inflation remains key concern for ECB

The recently released Eurozone inflation data barely slowed in February. Headline CPI eased a tad to 8.5% annual pace but remained above expectations of a slowdown to 8.3%. Meanwhile, core CPI accelerated to a fresh record high of 5.6% from 5.3%. Core inflation is the key focus for the ECB and the fact that it rose further warrants even more tightening.

How will EUR/USD react to the ECB’s rate decision?

The EUR/USD is likely to react positively to any hawkish surprise from the ECB given the increased financial stability risks in the US and the sharp repricing of yields lower over there. Thus, a 50-bps hike should send the EUR/USD higher, while a 25 bp hike could see rates drift back down to 1.0600.

Ahead of the ECB rate decision, the EUR/USD has broken above the 1.0700 resistance level owing to expectations that the ECB might tighten its policy more than the Fed over the next few meetings. The breakout has potentially paved the way for a run towards the next resistance level around 1.08 area – and possibly even higher, depending on the outcome of the ECB meeting.

The main risk for the EUR/USD right now is that if sentiment gets hurt so badly that the dollar finds support on haven flows. If the EUR/USD goes back below 1.0700 now and holds below this level, then this would put the bulls in a spot of bother.

Even so, the downtrend will not fully resume unless rates go below key support around 1.0500 this week. But if that level gives way, then we would expect to see follow-up technical selling towards the 200-day average and old support around 1.0340 next.

However, our base case assumption is that the EUR/USD will be able to climb higher as investors price out the risks of further aggressive rate increases from the Fed.

Final words

Given that inflation remains very high in the eurozone, we think that there is a good chance the ECB would not go against is strong guidance of a 50bp hike and thus disappoint market expectations for a lower increase.

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