How to trade overbought EUR/USD, as market focus on ECB

EUR/USD is on a dream run since January 2017 and now it is threatening to break its 2 year’s price range which is at 1.1712 level. The main reasons for this substantial rally are

The political situation becomes much more stable in Euro zone since French elections. Growth has also accelerated for last 3 quarters. Inflation is also started to move along towards ECB’s 2% medium term objective. On the other hand, US dollar has become more vulnerable due to a string of disappointing data which pointing towards economy-slowdown and inability of US Government to pass the Healthcare reform, which is also causing the delay for Tax reforms and Fiscal spending program. US trade policies for future are also uncertain which are causing unrest in financial markets. Fed chair Mrs. Yellen also became dovish after hiking interest rates 2 times this year, as she is now concerned about dipping inflation which she previously thought as transitory. She wants to see inflation moving higher before another rate hike. So FED is sidelined at this very moment which also making USD less attractive.

At such a crucial time, ECB will announce their monetary policy decision on Thursday, 20th July 2017.

So what are the market expectations?

Timeline for ECB’s QE program which they have started in 2014, is coming to end in December 2017. So now they have to decide whether they want to continue this for next year or they want to end it by starting tapering of QE from next year.

Last month, at central banks summit, Mr. Draghi acknowledged that downside risk for Euro zone economy has vanished and growth has come back on track. Traders took this as a hawkish signal to end QE and increasing rates from record zero level in 2018. So EUR/USD climbed from 1.1180 to present 1.1580 levels since then.

Now as expected they want ECB to tweak their statement towards a more hawkish side. As ECB already removed,”ECB may lower depository rates further if required in future”, in their last meeting statement, now EUR bulls want them to remove one more line from their tomorrow’s statement i.e “QE amount can be expanded in future if needed”.

So removal of this line is the need of EUR bulls right now as this alteration will open the door for tapering announcement which can be delivered on Jackson Hole summit which will be attended by Mr. Draghi on 7th August or in their next meeting in September.

Can ECB deliver this?

We are a bit skeptical about this due to following reasons:

Growth and inflation have just started to pick up from last 2-3 quarters and also inflation is currently at 1.3% which is well below ECB’s 2% target. QE’s fruit has just started to bloom.You don’t want to cut a tree fully without harvesting it fully. Also, they don’t want to face the same problem which FED is facing right now by relying on inflation trend in future.

Instability in Europe has been diminished but not vanished as Greece situation, Germany elections, Italy banking problems, BREXIT negotiations and US trade war still exist. Except for Germany, no other Euro Zone country can sustain with higher rates. Draghi already made a mistake by giving the market a hawkish signal last month, he won’t give second. And if they remove QE mention from the statement, one should remember that QE will not end overnight. Tapering will take at least 6 months to wind up and the rate will not rise before 2018 end.

So the market is very ahead of itself by expecting a rate hike in June 2018.

So how to trade EUR/USD around ECB:

There are 2 separate events

Release of statement Press conference

So basically there are 3 scenarios

If they remove the QE clause and also acknowledge it later in press conference

It will be a hawkish signal and EUR/USD will trade above 1.1712 levels and 1.2000 levels in near future are very much likely.

2.If they remove QE line but sound dovish in press conference

EUR/USD will try to reach at 1.1700 before press begins and it will fall later as it will be a setback for EUR bulls because it will be interpreted as ECB is not in hurry to wind up QE and rate rise will take more time. EUR/USD will come down to 1.1430 levels as Euro bulls will unwind their long positions and will wait for September speech.

3. If they don’t remove the QE line and also sound dovish

It will be a huge setback for Euro buyers and seller will take more control over it. And EUR/USD will come down to 1.1100 levels in near future as QE future will become uncertain.

We are inclined towards 2nd scenario as in medium term EUR/USD is looking very strong but ECB disappointment will take its effect also remember, from here on US economic data can also surprise us towards upside as downside has already been discounted. And a renewed hope will bring back FED in the picture.

Let’s see how this will play out.