© European Central Bank

- EUR on front foot after ECB decisions, forecasts surprise on upside.

- No cuts in pipe, little change to forecasts, TLTRO terms not generous.

- Eur pops but ING Group says it's "premature" to chase the rally higher.

The Euro surged Thursday after the European Central Bank (ECB) appeared to signal that it's not quite as downbeat about the Eurozone economic outlook as markets had come to believe it might be, although some analysts say it's premature for investors to chase the currency higher.

The ECB left its refinancing rate, marginal lending rate and deposit rate unchanged at 0%, 0.25% and -0.4% respectively on Thursday and did not give any firm hint of an interest rate cut being on the horizon. It did, however, say that rates will not rise until "at least through the first half of 2020", a downgrade from earlier guidance that suggested stability "at least through the end of 2019".

"The ECB strengthened its forward guidance slightly at today’s Governing Council meeting," says Andrew Kenningham, chief Europe economist at Capital Economics. "Given that investors were pricing in a small rate cut over the coming months, this may actually cause market rates to increase marginally."

Economic forecasts were left largely unchanged if-not downgraded by a touch. The Eurozone economy is now expected to grow 1.2% in 2019, up from 1.1% previously, but in 2020 and 2021 growth is seen at only 1.4% in both years. Previously it said the economy would expand 1.6% in 2020 and 1.5% in 2021.

A similar pattern was repeated with the ECB's inflation forecasts, where there was little overall change that relates to domestic demand drivers. The bank says inflation remains on course for a sustainable return to the target of "close to but below 2%", only risks are still seen as tilted toward the downside.

"Draghi did not elaborate on the “adverse contingencies” or when the ECB would use these instruments. Further falls in inflation expectations may be such a trigger. In the past, when markets were worried about a recession risk and inflation expectations had dropped significantly, the ECB announced major easing measures. Draghi stressed that global factors would be at play here," says Florian Hense, an economist at Berenberg.

Above: European Central Bank forecasts. Source: Berenberg.

"The ECB’s new forecasts, its forward guidance and the conditions of the new TLTRO appear to be designed almost as a direct challenge to the markets which have become entirely preoccupied with the idea that the global economy is on a brink of a recession," says Marchel Alexandrovich, an economist at Jefferies.

Since the last set of ECB forecasts were published President Donald Trump has raised tariffs on imports from China and the trade fight between the world's two largest economies is now on the verge of becoming an all-out economic conflict.

The U.S.-China trade war damaged the Eurozone economy last year when it first began so markets have been anticipating a further decline in growth this year. As a result the ECB's June upgrade came as a surprise, even though the prior forecast was a downgrade from the 1.7% projection of December 2018.

Meanwhile, the UK has failed to leave the EU, it's Prime Minister has resigned and the perceived risk of a 'no deal' Brexit as well as general election are rising. And the European Commission is again at loggerheads with the Italian government over its budget plans.

"At the moment, rather than panicked, the ECB appears almost bemused that market sentiment and perceptions of where rates could go from here seem to be driven by a single issue of a trade dispute which doesn’t directly involve the euro area," says Jefferies' Alexandrovich.

Above: Euro-to-Dollar rate shown at hourly intervals.

What took the market by surprise Thursday was the bank failing to validate market bets that an interest rate cut is in the cards for the next 12 months while also further signalling, through pricing of the new targeted-long-term-refinancing-operation (TLTRO), that it's not as downbeat on the outlook as was feared.

The ECB says the interest rate on the TLTRO, which will see comercial banks furnished with more cheap cash to lend to companies and consumers to stimulate activity, will be set at 10 basis points above the average interest rate applied in the "refinancing operations" over the life of the programme.

That refinancing rate is currently 0% and consensus had been for the ECB to make the cost of the cheap loans equal to the current refinancing rate. The fact the ECB chose not to match it in the latest TLTRO operation could be taken as a signal the bank is not quite as downbeat on Eurozone economic prospects as many had thought.

"Calling for an imminent and pronounced EUR/USD upside break from here may be premature as the ECB is unlikely to stand idle if and when the Fed eases. Moreover, as will be the case for the US growth, the eurozone economy will be also affected by the trade wars given the very open nature of its economy," warns Petr Krpata, a strategist at ING Group.

Above: Euro-to-Dollar rate shown at daily intervals.

Markets care about the European Central Bank decision because changes in interest rates, as well as the outlook for them, can have a significant influence over international capital flows as well as speculative short-term trading activity. Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates seeing investors driven out of and deterred away from a currency.

ECB policymakers are obliged to ensure inflation remains at the target of "close to but below 2%", although its only gotten near 2% on a handful of very brief occasions in recent years. And the more important core inflation rate, which is seen as a truer representation of domestic price pressures because it excludes certain items, has been even lower for longer.

The ECB needs faster growth and lower unemployment in order to generate the wage increases and economic demand necessary to sustainably return the consumer price index to its target. It needs an all-out U.S-China economic conflict, a possible U.S.-EU trade war and a 'no deal' Brexit like anybody might need a hole in the head.

"There is still President Trump’s decision on the EZ auto-tariffs to be made. As per 'World trade heading for the worst year since 2009', our trade team believes the auto-tariffs will be imposed in 4Q19, which also limits the EUR/USD upside potential as this would be a clear negative for the eurozone economy," Krpata warns.

Above: Euro-to-Dollar rate shown at weekly intervals.

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