ECB Decision Looms: Euro's Lose-Lose Situation

Today's spotlight is on the European Central Bank's (ECB) decision, where markets have priced in a 65% probability of a rate increase. Despite various leading indicators hinting at the Eurozone teetering on the brink of recession, the persistence of underlying inflation dynamics, combined with rising energy prices, has swayed the balance in favor of a final rate increase. Reports suggesting that the ECB would revise its 2024 inflation forecasts have further fueled speculation of an imminent rate hike. This could be seen as an intentional 'leak' from the ECB to shape market expectations ahead of the meeting.

For the euro, this situation appears to be a lose-lose scenario. Implementing further rate hikes while the growth outlook remains grim could be viewed as a policy mistake, potentially intensifying the pressure on an already fragile economy. Therefore, even if the euro experiences a temporary surge following a rate hike, any gains might be short-lived as concerns arise about whether higher rates will stifle growth further and lead to more substantial rate cuts next year. Conversely, if the ECB refrains from raising rates, it would catch investors off guard, causing an immediate decline in the euro due to the contrast with market pricing.

In summary, the euro faces an unfavorable outlook. Economic growth is decelerating, and rising energy costs will exacerbate the strain on both economic activity and the bloc's terms of trade. Additionally, there is significant exposure to a slowing Chinese economy. In contrast, the US dollar boasts robust fundamentals, making the euro/dollar outlook increasingly negative, regardless of the ECB's decision.

Dollar's Response to US Inflation

In the broader market, the US Consumer Price Index (CPI) report for August showed a slight uptick, but it failed to rattle investors. The marginal upside surprises were insufficient to alter the Federal Reserve's calculus. Following the CPI release, the US dollar and US yields initially climbed before retracing lower as markets settled. The decline in the 10-year yield appeared to be a technical rejection as it encountered resistance near its cycle highs of around 4.35%, without any other significant catalyst.

Stock markets capitalized on the yield pullback, posting gains, with rate-sensitive sectors like technology and growth leading the charge.

However, the equity market's outlook remains unattractive, characterized by stagnant earnings growth, stretched valuations, and a liquidity-reducing central bank backdrop. Real bond yields near a decade-high level add another layer of complexity to this equation.

Gold's Decline and US Retail Sales

Gold continued its downward drift on Wednesday, despite the retreat in Treasury yields. The strength of the US dollar outweighed the pullback in yields, driving gold lower towards the $1,905 level. Looking forward, near-term risks for gold remain tilted to the downside. The dollar rally appears to have more room to run, supported by technical patterns showing a series of lower lows and lower highs in gold prices. For gold to regain its luster and push toward new record highs, a resurgence of recession fears might be necessary, fueling expectations of Fed rate cuts and reducing yields.

However, considering the resilience of US economic indicators, such a shift does not seem imminent. Investors will gain insights into the state of the US economy through today's releases of retail sales and producer prices for August.