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Will the ECB and BOJ justify wide bond spreads and the dollar rally?

The European Central Bank’s two-day policy meeting will conclude on Thursday with the release of the central bank’s interest rate decision and will be followed by a press conference with ECB President Mario Draghi.

What to expect

We don’t expect the Governing Council to make any changes to current policy, with interest rates forecast to remain frozen and the current quantitative easing programme to remain constant with purchases of €30 million per month.

We expect the ECB to acknowledge that on the whole economic data has weakened since the last meeting. Inflation, which has been stagnant for most of the past year, missed expectations in March, printing at 1.3% rather than the 1.4% forecast. Inflation for the bloc remains stubbornly below the central bank’s 2% target. Geopolitical risks have also increased since the last meeting and whilst trade war fears have eased back from the brink, geopolitical tensions remain elevated.

The combination of weaker economic data, softer inflation, and raised geopolitical tensions suggests that we could hear a slightly more cautious sounding statement from the ECB. However, comments from ECB policymakers this morning have been more optimistic regarding future inflation expectations throwing some doubt over a more cautious stance. Even so, we expect the majority of governing council members to continue to support a very gradual approach to tightening policy and no comments on how the quantitative easing programme will end.

The reality is that the central bank will want more time to judge if the eurozone economy is overcoming the slowdown which has been prevalent in the first quarter. With this in mind, even the June meeting could be too soon for the ECB to say how they will end or taper the current bond-buying programme.

EUR/USD to $1.21 post ECB meeting?

EUR/USD is under pressure ahead of the ECB meeting, trading around $1.22 handle. US yields have been on the rise over the past week, hitting the psychological 3% mark overnight, as markets anticipate higher US inflation and a more aggressive path of tightening from the Fed. This week the gap between the US and German 10-year government bond yields have hit its widest in 29 years, as diverging inflation expectations and interest rate expectations are played out.

A slightly more cautious sounding Draghi could see this divergence amplified, which would pull the EUR/USD to support seen at $1.2160 before opening the doors to $1.2100. On the contrary, a more hawkish ECB could lift the pair to $1.2270 prior to $1.23.

USD/JPY to rally following BoJ meeting?

Whilst investors will be looking closely to divergences between ECB and the Fed’s expected path of rate hikes, the BoJ could also amplify broad differences with other central banks when their two-day policy meeting concludes on Friday. The debut of a new dovish deputy could exasperate an ongoing rift in the BoJ over continued stimulus versus the costs involved. Whilst the new deputy is not expected to rock the boat at this meeting, his presence, in addition to the rising US bond yields is drawing in the market’s attention.

The US – Japanese 10-year treasury yield spread is at its widest level in 11 years. USD/JPY is trading firmly above 109.00, with a dovish BoJ and a continued rally in US yields potentially sending the pair towards the 200 sma at 110.28 before key resistance at 112.44.

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