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2 things to watch out for at this week’s ECB meeting

on Oct 24, 2022
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  • ECB to hike the key interest rates by 75bp at this week's meeting
  • The euro may squeeze higher if the ECB decides to make TLTROs less attractive for commercial banks
  • The risk is that the ECB will overdeliver and hint at a higher neutral rate than the market expects

The European Central Bank (ECB) meeting is the main event of the week for currency traders. The pressure mounts for the ECB to tighten its monetary policy faster, given rising inflation in the eurozone, and the central bank will likely deliver.

Heading into the meeting, the risk is that the ECB will overdeliver. Hence, the euro is in a position of a possible short squeeze.

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Interestingly enough, it is not the rate hike that should lead to the euro’s rally but the ECB’s decision on TLTROs (Targeted Longer Term Refinancing Operations).

What would be the neutral rate?

The first thing to watch is any hint from the ECB President, Christine Lagarde, regarding the neutral rate. The odds are that the ECB sees it at 2% by the end of the year, meaning a 75bp rate hike to be delivered at this week’s meeting and another 50bp hike in December.

However, the ECB may surprise and hint at another 75bp rate hike in December, given the ongoing broadening of inflationary pressures. If that is the case, the euro should rally because the market still needs to price in such a possibility.

Potential for a faster pace of balance sheet reduction

The rate hikes, however, are not likely to move the euro, as is the potential for a faster pace of balance sheet reduction. Traders should remember that the market moves in anticipation of what is about to happen in the medium and long term, and this week’s meeting may result in a decision meant to drain the liquidity by about EUR 1 trillion or so.

The focus, therefore, at this week’s meeting is on the ECB’s decision regarding the attractiveness of the TLTROs. Currently, commercial banks benefit from very attractive conditions on these loans, which increased the reserves by about EUR 4.7 trillion.

Rumors are that the ECB would make TLTROs less attractive and thus, commercial banks would start repaying them faster. Hence, the balance sheet reduction by Q2 2023 from TLTRO repayments only would drain more than EUR1 trillion from the system.

Euro should fly on the news, as such a decision has far bigger implications than the rate hikes already priced in.

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