Investors left guessing how ECB will tackle strong euro

London

INVESTORS want to know how the European Central Bank is going to tackle the euro's strength.

It's been a guessing game since ECB chief economist Philip Lane said "the euro-dollar rate does matter" hours after the common currency breached US$1.20 for the first time in more than two years.

Money markets priced in a 10 basis-point cut in the main policy rate by next September, the euro tumbled and bonds advanced, all on the assumption that the central bank will eventually do more than just talk down the euro. A stronger currency makes it harder for the ECB to reach its inflation target.

"It seems highly likely that the next ECB meeting will have a dovish slant, partly in response to the strength of the euro," wrote Jamie Searle, a rate strategist at Citigroup. "A change in policy stance seems unlikely, however."

The market moves were driven by expectations that the ECB may give guidance on whether it is considering more stimulus, potentially weakening the currency. Curbing the euro would increase the competitiveness of European exports and raise inflation, which turned negative for the first time in four years, by making imports more expensive.

If the ECB president Christine Lagarde stresses the negative implications of currency strength, the market will price further rate cuts, according to UBS Group strategists including Rohan Khanna. Most economists forecast an increase in stimulus by December.

"The ECB may have problems with the euro - and certainly with inflation - but it already has a tight grip on euro rates," said Mr Searle, who sees the ECB increasing its bond-buying programme by 500 billion euros (S$808 billion) in December. "The ECB can easily reprice bunds if it wants to" by cutting the main policy rate, he added. BLOOMBERG