Summary:

• The US dollar was a touch stronger against risk currencies on Wednesday, as markets braced for news on the Nord Stream 1 gas pipeline on Thursday.
• The European Central Bank will also be meeting this afternoon. We think there is a very good chance of a 50 basis point interest rate hike. Markets will also be looking for details on the bank’s new anti-fragmentation tool.
• Sterling shrugged aside yesterday’s UK inflation beat, which we think raises the possibility of a 50bp rate increase from the Bank of England at its August meeting.

The main gas pipeline between Russia and Europe, the Nord Stream 1 conduit, is set to reopen on Thursday following a ten day shutdown period. While markets are clearly optimistic that it will open as planned, there still remains a degree of uncertainty as whether this will actually be the case. Any meaningful delay would likely ramp up expectations for a Euro Area recession this year, and could trigger a fresh move lower in the common currency, though we stress that this is not our base case scenario and think that further upside is possible in EUR/USD should the the pipeline open as scheduled today.

Markets will also be on tenterhooks ahead of this afternoon’s European Central Bank meeting. The ECB is guaranteed to raise interest rates for the first time in more than a decade on Thursday, finally following in the footsteps of almost all of its major counterparts in the current cycle. But, as we said in our ECB preview report, we do not rule out a 50 basis point interest rate hike, indeed markets now see this as more likely than not. Headline inflation in the Eurozone has continued to far exceed expectations, and has shown no signs yet of easing, rising to 8.6% in June. This could encourage policymakers to front-load the pace of tightening, particularly given the inflationary implications stemming from a weaker euro.

Aside from the rate decision itself, markets will be paying close attention to details on the bank’s new anti-fragmentation tool. There is an expectation that additional details on how the ECB plans to close peripheral bond spreads will be announced this afternoon – a failure to do so will be seen as a big disappointment to markets and may lead to a weaker common currency.

Should the ECB convince markets of its ability to calm the situation in the bond market, and accompany this with a 50 basis point rate hike, then the euro would likely rally hard. By contrast, should they fail to do either of these things, and we get less than favourable news on the Nord Stream 1 pipeline, then we wouldn’t rule out a fresh move towards parity in the key pair this week.

Meanwhile, sterling largely brushed aside this morning’s stronger-than-expected UK inflation print. While the core measure of inflation is showing signs that it may have peaked, the continued sharp increase in food and energy prices has driven the headline rate to fresh multi-decade highs. The cost of living crisis presents the biggest downside risk to the UK economy during the remainder of 2022, and we think that tougher action is warranted from the Bank of England at upcoming MPC meetings. Governor Bailey warned on Tuesday that policymakers would consider a 50 basis point interest rate hike at the August policy meeting. We have been saying for a while that it is high time the BoE joins the ‘50 club’, and see it as highly likely that they will finally do so when ratesetters next convene in a couple of weeks’ time. Investors are finally coming around to this view, although with a 50 bp hike yet to be fully priced in by swap markets, we think there remains room for a recovery rally in sterling from current levels.

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