Image © European Central Bank

The Euro to Dollar exchange rate (EURUSD) is on track to extend its current decline according to a new analysis that finds the market is mispricing the odds of another European Central Bank interest rate hike.

The ECB meets again next week with markets seeing a near 50/50 chance of interest rates being lifted by a further 25 basis points in light of elevated inflation levels.

But Jeremy Strech, an analyst at CIBC Capital Markets, says the slowdown in the Eurozone economy will prove dramatic enough to prompt the ECB to forgo a hike in a move that could result in further Euro weakness.

"The ongoing capitulation in EU real economy data remains in evidence. The latest example comes via German industrial output having contracted by 0.8% in July, the retreat proved to be double that expected," says Strech in a daily currency update.

He says the slide in German activity underlines the correction in the Eurozone's economic surprise index which yesterday witnessed the most aggressive daily downside move in two weeks.

Currencies tend to react to data surprises, rising when data beat expectations but falling when they undershoot.

"Stagnation in industry and the broader economy looks like the new normal for Germany – Europe’s biggest economy. In fact, the full batch of hard German macro data for July suggests that the risk of recession is high again," says George Vessey, FX and Macro Strategist at Convera.

The surprising weakness in the economy will have to be considered by the ECB which is yet to officially signal any major concerns about the direction of the economy.

Any such concessions at the September meeting could be interpreted as being 'dovish' and consistent with Euro weakness. "All of this bodes ill for the euro and the negative bias is likely to persist in the short-term," says Vessey.

Money market pricing shows investors are pricing in around 17bps of ECB tightening by year-end, something the team at CIBC Capital Markets view as being too rich when the data is taken into account.

"The market currently prices around 8.5bps for next week's ECB. We expect policy inertia as the weak data trend, leading to a rolling over in services prices points towards an on-hold decision," says Strech.

"ECB inertia on the back of weak data opens up a test of the 8 June low at 1.0695, below here the next line of support comes in at 1.0635 in line with the 31 May low," he adds.

Above: EUR/USD at daily intervals with the afformentioned downside support levels identified.

But economists at ING Bank, the Dutch-based lender and investment bank, see one more interest rate hike coming this September, a move that could potentially boost the Euro given current market expectations for rates to be held unchanged.

"We admit that it is a very close call, but still too high inflation, a focus on actual rather than on predicted developments, and the fear of stopping prematurely will tilt the balance towards a final rate hike next week," says Carsten Brzeski, Global Head of Macro at ING Bank.

Convera's Vessey says "the common currency may find support if the ECB opts to raise rates this month. ECB policymakers have recently talked up the chances of more rate hikes, even for this month, stating markets were underestimating this probability."

The Euro-Dollar exchange rate has fallen from a July high at 1.1275 to 1.0699 at the time of writing amidst a broader push higher in the U.S. Dollar which appears to be benefiting from disappointing data elsewhere.

U.S. data meanwhile continues to impress to the upside, reinvigorating the U.S. 'exceptionalism' trade, and some analysts are keen to point out that the recent spike in oil prices will add to USD momentum.