Image © European Union - European Parliament.

Any strength in the Euro to Dollar exchange rate following today's European Central Bank interest rate decision would likely be short-lived, according to research from Bank of America.

In a preview of today's decision, analyst Athanasios Vamvakidis says the market is likely to witness temporary strength in Euro-Dollar, but this will soon fade as the exchange rate journeys towards its year-end target nearer 1.05.

Economists at Bank of America look for the ECB to hike interest rates by 25 basis points, but concede that the outcome is finely balanced.

This reflects the broader analyst community which is essentially 50/50 on the outcome with market pricing also showing investors to be split, suggesting the potential for some interesting knee-jerk moves in the wake of the decision.

Nevertheless, Bank of America's Europe economist Ruben Segura-Cayuela says recent news should tip the ECB into a hike:

1) a weaker growth outlook (but no recession),

2) inflation almost (or fully) converging to target by the end of the forecasting period, but stronger inflation near-term,

3) small upticks in inflation expectations and unit labour costs and

4) no clear evidence of a peak in core inflation

Regarding the all-important signals regarding future moves, Bank of America expects little explicit forward guidance from the ECB but the bias will be towards doing more or pausing, and certainly not cutting.

This is because the ECB, like other central banks, will be comfortable with market expectations in peak rates, but loathe to prompt an easing in monetary conditions for fear it will stimulate inflation.

But, Bank of America reckons the end of the cycle is here and August will see the window close on further hikes.

Above: EUR/USD vs EUR-USD real rate spread. Source: Crédit Agricole CIB, Bloomberg.

"While our conviction on the September hike is not strong, we do have strong conviction that, absent major surprises, if they don’t hike this week, July would be the last hike of this cycle. If the data is not strong enough to warrant a hike this week, it is unlikely to justify a hike later, when activity will remain weak, and inflation will likely weaken more," says Segura-Cayuela.

Bank of America expects the first ECB rate cut in June 2024 at the earliest, and only one cut per quarter throughout 2024 and 2025.

"If we are right and inflation underperforms in 4Q, the ECB will need forward guidance on the timing of the first cut to stop the market from pricing early and fast cuts," says Segura-Cayuela.

Whatever the case, the ECB looks to have just one interest rate hike left in its pocket given the rapidly cooling economy, meaning any post-decision moves could soon fade.

Euro Forecasted Lower

From a foreign exchange perspective, Bank of America's currency strategists say they are looking for some temporary EUR strength if the ECB indeed hikes.

"Even if the ECB stays on hold, we would expect their language to make it clear that this is a skip, not a pause, although in practice it may turn out to be the latter," says Vamvakidis.

"We would not expect the EUR to strengthen by much in any case, as the market is already pricing a high probability of a last hike by the end of this year (22bp)," he adds.

Looking towards year-end, the main driver of the Euro will remain relative data, according to Bank of America, and the growth-inflation trade-off seems to have been much better in the U.S. than in the Eurozone, supporting the USD.

"We also expect one more hike by the Fed, in November, which is not fully priced (market is pricing 13bp by December). We stick with our EURUSD forecast of 1.05 by year-end," says Vamvakidis.