Inflation statistics for Germany misled the markets at the moment. Judging by the slowdown in the indicator in the locomotive of the European economy, some players began to anticipate a possible peak in inflation. A similar report from Spain somewhat grounded the markets, as inflation in this country was higher than expected.

Inflation Rate in Germany (M/M)

Market players will now look for clues on how the European Central Bank will behave at the upcoming meeting in July. Will the central bank take into account the fact that the worst of the current spikes in inflation may have passed and it will be possible to apply a less aggressive approach to raising rates.

At the moment, the ECB is ready to raise rates in July and then in September. The size and number of upcoming increases matter for the euro. If the meeting talks about 50 bp, it will be seen as a strong commitment to normalizing policy and potentially support the single currency.

The softening of inflation indicators may be a good reason for a symbolic rate hike– by only 25 bps. This will disappoint the players, as they are already set up for a more aggressive approach by the ECB. Lower inflation data may also mean a reduction in the frequency of rate hikes. In other words, the tightening will not happen monthly, as investors think.

Prior to the release of inflation data, the markets predicted a rate hike of at least 30 bps. The main scenario, after all, was an increase of 50 bp, besides, this figure increasingly surfaced in analytical and financial reviews.

It is worth noting that on June 13, the market expected the ECB deposit rate to peak at 2.48%, but since then it has fallen and as of June 27 was at 2.04%. There is reason to believe that this value will become even lower further.

Holding back expectations of a rate hike will trigger a mechanical reaction of the euro's decline, as was seen at midweek trading. Consequently, the summer consolidation of the EUR/USD pair may be limited to 1.0350-1.0642, and not 1.0350-1.0800.

Be that as it may, the euro does not look completely hopeless. Annual CPI in Spain for May was 10.2%, which is higher than expected 9% and 8.7% for the previous period. It is too early to talk about the stabilization of the inflationary situation in the euro area as a whole, so the ECB is likely to maintain its current rate.

Bank of America Forecast

The euro's weakness is due to the softness of the ECB and the periphery. When it comes to a raise, it will be difficult for the central bank to keep up with other major central banks tightening policy. The policy divergence between the major central banks will be a key driver of the exchange rate in the coming months, according to Bank of America.

The ECB was left with the lowest interest rate in the G-10. While the majority is starting a quantitative tightening (reversal of easing) program, the ECB is only now about to complete its quantitative easing.

Analysts are convinced that Europe will not begin quantitative tightening until at least the end of 2024. The rate is likely to be increased by 25 bp in July.

The ECB will remain dovish compared to other members of the Big 10 until it eliminates the risks of fragmentation. In this regard, market players will pay more attention to how the ECB solves the issue of curbing the yield of Italian and Greek bonds.

Failure to solve this problem is highly likely to destabilize the eurozone and, therefore, is a key risk for the prospects of the euro.

However, ECB representatives have recently started talking about tools to ensure that the difference in bond yields between different countries remains stable, thereby containing risks. The information was once again reiterated by ECB President Christine Lagarde during her speech at the annual ECB forum.

In the near future, there will be a plan according to which the central bank will continue to buy bonds of vulnerable countries, which will limit the yield that these bonds pay, and therefore limit the cost of borrowing.

To compensate for the stimulus, the bank will pump out liquidity from other parts of the system, potentially offering banks attractive interest rates to hold cash with the ECB, Reuters reports. This is known as the "sterilization" program.

Bank of America has little faith in promises. If we are talking about the development of an instrument, this means that it is not in the ECB.

Bank of America's medium-term forecasts for the euro remain pessimistic until the end of this year. In the long term, a gradual return to equilibrium is expected.

"We maintain our forecast for EUR/USD for this year at 1.0500, which is still below the consensus forecast of 1.1000," analysts write.

In 2023, the quote is expected to be at the level of 1.1500, increasing to 1.2000 in 2024. Nevertheless, uncertainty remains high for these years as well.