Image © European Central Bank

Foreign exchange market focus is likely to turn to the European Central Bank (ECB) today where traders will be looking for any significant shift in policy that might impact the value of the Euro.

The Eurozone economy has slowed significantly through the second half of 2018 and there are little signs of a material pickup in performance thus far in 2019. There is therefore a heightened chance that the ECB takes steps to assure markets that it will continue to provide support for the Eurozone economy.

The extent of any additional support matters: After all, it is the gargantuan printing of money, and the guarantee of artificially low interest rates from the ECB in the post-Eurozone sovereign debt crisis era that is widely credited for keeping Euro exchange rate valuations under pressure.

The ECB had been expected to take a decisive path to normalising policy in 2019, but a slowing economy prompted markets to keep the Euro under pressure in anticipation of more-of-the-same from the ECB on the policy front.

The one acronym readers must be on the lookout for today is TLTRO. The TLTRO programme - Targeted Longer-Term Refinancing Operations - saw the ECB give banks a total of €739BN of cash in two four-year periods, starting in 2016 and 2017.

The reason TLTROs are back in focus is because the ECB senses banks need further encouragement to keep credit lines to the economy open. Of late lending data has shown a drop in corporate lending growth, in line with the tendency of banks to cut back on lending during slowdowns.

The ECB is being tipped to either 1) prepare markets for a future commencement of another TLTRO programme or 2) announce a TLTRO programme today.

As the the programme effectively pushes fresh, 'easy money', into the Eurozone, it is on margin negative for the Euro.

However, markets have already more-or-less priced in this announcement, therefore the TLTRO itself might not shake markets. Remember, when it comes to currencies, surprises are what count and ECB President Mario Draghi has become a master at delivering statements aimed at avoiding market volatility.

"The ECB is expected to announce new rounds of long-term liquidity funding (so-called “TLTRO’s”) for eurozone banks, but it is not entirely certain that it will, and the details of the programme will be important," says Ingvild Borgen Gjerde at DNB Markets. "The ECB’s ability to ignite significant market response at its policy meeting today is limited, in our view, and any moves in the Euro or core government bond yields should prove short-lived."

The scale of any new programme could be where the surprises lies.

The ECB is also today expected to lower its growth and inflation forecasts, but to what extent, and the implications this will have on policy, is uncertain. A deep cut to growth and inflation forecasts could be taken as a negative by markets and the Euro could come under pressure as it signals the potential for more aggressive intervention at the ECB at future dates.

"While there is still downside potential in the Euro, we think the ECB would have to be very dovish to trigger further Euro weakness, and this it is not capable of," says Gjerde. "While this does not rule out a scenario of the Euro continuing to weaken, we see limited potential for the ECB to be the trigger behind such a move."

There is a chance the ECB strikes a more constructive tone than markets had been expecting which would be surprising outcome and therefore one that could have a greater upside impact on Euro exchange rate price action.

However, even here the likely positive impact on the Euro is seen as being limited in duration.

"The potential for hawkish surprises is, for obvious reasons, bigger. The ECB could delay an announcement of new TLTRO’s, it could keep its forward guidance unchanged (which is highly likely, in our view), and it could be more optimistic on the outlook for growth and inflation than investors think," says Gjerde.

DNB Markets are unconvinced that any hawkish surprise from the ECB would spur significant and lasting market reactions, simply because of dynamics in the German bond market.

The Euro is positively correlated to German bond yields: When they rise foreign investors buy Euros in order to benefit from the improving returns offered by one of Europe's safest and most liquid investment vehicles.

However, Gjerde says the force of gravity acting as a drag on German government yields has proven extremely strong recently. In short, when demand for a bond grows, its yield comes down.

"There are plenty of investors willing to buy on dips and prevent German Bund yields from rising meaningfully. Thus, we think a sell-off in Bunds and other core eurozone bonds following a hawkish surprise from the ECB today will prove short-lived," says Gjerde.

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