Here's why Draghi could disappoint markets today

Just hours ahead of the European Central Bank's monetary-policy announcement saw profit taking drive EUR/USD off its highs. Hawkish comments are not a done deal so we could see further unwinding of long euro traders ahead of European Central Bank President Mario Draghi's press conference on Thursday. The ECB is widely expected to leave interest rates and its asset-purchase program unchanged but economists and investors are divided on the degree of Draghi's hawkishness.

Here are the facts: we know that Mario Draghi is thinking about changing policy from an accommodative to neutral stance but that was when EUR/USD was trading at 1.12 and not 1.15. We also know that the ECB is not happy with how much the euro has risen off these comments because a day later, when EUR/USD rose from 1.12 to 1.14, they said the market misinterpreted Draghi's guidance. The Eurozone economy is on the path to recovery but as shown in the table below, inflation is low, recent activity is mixed, investor confidence has fallen and financial conditions tightened. German bond yields doubled since ECB's last meeting in June and the euro is at 1-year highs. For an export-dependent economy with low inflation, the rise in the currency reduces the pressure on the central bank to remove policy accommodation. But the euro is still cheap on a 5- or even 10-year basis and there's no doubt that Draghi is in the same head-space as Yellen, Poloz and Carney — who all believe that it's time to normalize monetary policy.

So where does that leave the euro going into this month's monetary-policy meeting? We think the ECB will disappoint. If it talks taper now, the EUR/USD would break 1.16 and probably rise as high as 1.20 ahead of the September rate decision, when the ECB forecasts will be released and when we expect the central bank to reduce asset purchases. It is in ECB's best interest to halt the one-way move, ease the euro off its highs by repeating that inflation is not on a self-sustainable path and then gradually set expectations for taper from a lower base. That way, instead of driving the euro to 1.20 on hawkish comments on Thursday and then setting it on a course to 1.25 when ECB officially reduce asset purchases, it could take some of the steam out of the rally now and manage it higher later. Ultimately, ECB policy is moving in the direction of less accommodation so even if the euro dips, it's a buy into the September rate decision.

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