ECB to prepare the way for additional stimulus by year-end

An increasingly cautious Fed, coupled with an uncertain EM outlook, has benefited the EUR recently, contributing to tighter euro area financial conditions. Coupled with the recent drop in inflation expectations, such tightening has significantly raised expectations for additional ECB stimulus, making this week's ECB meeting (Thursday) the market's key focus. Notwithstanding recent statements by ECB staff, the most likely scenario is a continuation of the dovish rhetoric, followed by the announcement of a QE time extension in December, when the ECB updates its Q4 15 staff economic forecasts. 

"Given additional stimulus expectations as early as this week, we see a risk for EURUSD to squeeze higher should President Draghi withhold any signals regarding further policy measures", says Barclays.

However, preferably via options, as a stronger EUR would only exacerbate recent tightening, adding even further pressure to the ECB. Moreover, recent price action in front-end euro rates suggests that the market is pricing a non-zero probability for a further deposit rate cut. While this possibility can't be rule out, it is not expected to be an option for the next two meetings. However, it is estimated that the rates market is already pricing a 20% likelihood of a 10bp deposit rate cut before year-end. A likely trigger for a rate cut would be a further material appreciation of the euro, possibly related to more signs that the Fed will remain on hold for longer. Although a measure of last resort, such policy action would be the most effective in weakening the EUR.

With all eyes on the ECB, there is little data worth mentioning this week. Euro area flash composite PMIs (Friday) is expected to moderate further in October, as the manufacturing and services sectors post slight drops (to 51.5 and 53.2, respectively). There should be some decline in German confidence due to the emerging market slowdown, disappointing recent activity data and the VW scandal. In France, volatility should remain, with PMIs consolidating slightly after last month's rebound. Overall, Q3 growth is expected to soften in line with August euro area industrial production.