ECB Preview: Hike Expected as Oil-Driven Inflation Bites

The European Central Bank is set to raise its deposit rate by 25 basis points to 2.50% on Thursday, its second hike since the Iran war reignited over the summer. The decision is due at 13:15 UK time.

Policymakers are expected to frame the move as insurance against an oil-driven inflation spike rather than the start of a fresh tightening cycle, leaving traders to weigh whether one more hike is enough to keep supporting the euro or whether its gains stop here.

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·         The ECB's deposit rate stands at 2.25% heading into Thursday's decision, with a 25 basis-point hike to 2.50% widely expected.

·         EUR/GBP trades around 0.8588 on Thursday, pressing into the trendline that has capped every bounce in the pair since last November.

·         Brent crude sits near $101 a barrel, about 15% above its 200-day average, after the Iran war disrupted flows through the Strait of Hormuz.

·         The UK 10-year gilt yield hit 5.268% earlier this month, an 18-year high, as the same energy shock pressures British borrowing costs.

One Hike and Done, or Just the Start?

Thursday's hike itself is barely in doubt so as almost always, it’s about what comes next.

A Reuters poll of economists found broad agreement the ECB would lift its deposit rate to 2.50% this week, and 90% expect it to stay there through year-end. That near-unanimous consensus is what makes the move a tricky one for the euro.

A hike that's fully priced in before it happens tends to have little left to give a currency on the day itself.

What will matter more than today's 25 basis points is what ECB President Christine Lagarde signals next. Bundesbank president Joachim Nagel has kept to a meeting-by-meeting line, saying oil and gas prices “keep going up and down” and that “there are many uncertainties” ahead.

Markets still price a chance of another move in December, but with rates set to sit near the top of the ECB's estimated neutral range after today's move, a pause looks the likelier path unless second-round effects show up in wages and core prices.

Can a Rate Hike Really Fix an Oil Problem?

The tension underneath all of this is that oil-driven inflation isn't the kind rate hikes are built to fix.

A 25 basis-point move doesn't reopen shipping lanes through the Strait of Hormuz or bring Brent down from its current $101 a barrel. What it can do is stop a temporary energy shock feeding into wages and other prices, the second-round effects that turn a one-off spike into something more persistent.

That's the real case for treating today's expected hike as insurance rather than the start of a series. Underlying inflation and wage growth have both been softening even as the headline rate ran to 3.3% in August, its highest in three years, exactly the kind of split that argues for treating the oil shock as temporary rather than fighting it with hikes that would do little to change the price of crude and plenty to slow growth elsewhere in the bloc.

A Bigger Squeeze on the Pound

The same oil shock that's testing the ECB is also squeezing the UK's public finances.

The UK 10-year gilt yield touched 5.268% earlier this month, its highest since 2008, while Chancellor John Healey's fiscal headroom against his own budget rules has roughly halved since March, narrowing his room ahead of the October 28 Autumn Budget.

The Bank of England holds its own decision next Thursday. It held rates at 3.75% in July on a 6-3 vote, and hawkish dissent has grown from one member in April to three in July, making a hike to 4.00% a live risk alongside a pound already trading on fiscal jitters.

EUR/GBP: Testing the Trendline That's Held Since November

EUR/GBP is running into the same descending trendline that has capped every rally in the pair since last November.

The pair broke down through the 0.8580-0.8620 support shelf in late June, fell to a low near 0.8450 in early July, and has spent the two months since building a tighter base in the 0.8550-0.8600 range. The 14-day RSI at 59, rising but nowhere near overbought.

The very low volatility marked by a series of short-range daily candles suggests a possible spark in volatility is coming. Near term momentum is bullish but the longer term downtrend remains intact.

Source: SpreadEx | EUR/GBP, Daily Chart