After EUR/USD enjoyed a spectacular rebound after the Italian referendum, the next big event is the ECB. Here is the view from Morgan Stanley:

Here is their view, courtesy of eFXnews:

We believe the reaction of the EUR over the ECB meeting will ultimately depend on the probability of tapering in the next 12m. In particular, EURUSD will rely on the short end rate differential between EMU and the US.  Our economist’s assumption is that the ECB will keep rates on hold at next week’s meeting but add a 6m extension to its QE purchase program.

What is the market expecting?

Rates – no cut is priced for the December meeting and only 3.5bp by the end of 2017. The first hike is now 38 months away in 2020 instead of 60 months away as was priced at the end of October.

QE – the level of a bond yield is unable to give us an accurate measure of what the market is “pricing” regarding further government bond purchases. Our only estimate is via speaking to our clients. Recent discussions suggest the majority of macro investors are not assuming the ECB will taper in 2017, indicating another extension would come in September.

Potential Scenarios and EUR response

1) Extends QE purchases for six months beyond March at the current pace of 80bn/month. Expected by many market participants, already hinted at by ECB members speaking to MNI news, wouldn’t be surprising for markets. Limited EURUSD impact. To extend purchases and leave an expectation in the market that they could extend again, the ECB would need to make some tweaks to its current program that limits the scope for purchases. Here are some tweaks that the ECB could make and the potential EUR impact.

-a) No longer using the capital key to allocate purchases. As this approach could be bearish for the German bund but bullish for the periphery, we think the EUR could react positively. Note that the ECB doesn’t necessarily need to explicitly express it is moving away from the capital key, they could indicate that they plan to be more flexible, in which case the EUR reaction should be limited. The market impact would be more volatile if they are explicit.