ECB Meeting: Taper priced in? EUR could drop if Italian yields spike

The European Central Bank (ECB) is likely to begin tapering its EUR 2.3 trillion stimulus program on Thursday.

It is widely believed that the central bank will do a balancing act by announcing a 'lower-for-longer QE' - check out preview here for more info on - expected taper amount, possible changes to forward guidance, central bank's take on EUR appreciation and its impact on inflation and issue of scarcity of bonds.

The taper has been priced in

The taper has been priced in the second quarter this year - Eurozone bond yields spiked and EUR rallied after a Bloomberg report said, "the ECB fell short of its target for purchases of German bonds under its quantitative-easing program for a third straight month in June". The evidence of a shortage of available bonds in Germany, Ireland and Portugal saw market price-in "taper by force", i.e. ECB will taper QE due to technical issues, i.e. shortage of bonds.

The talk of "lower-for-longer QE taper" has been in the air for quite some time. Still, the EUR/USD has remained above 1.17, which suggests the dovish taper won't be a surprise to the markets. EUR is unlikely to fall more than 100 pips on 'dovish taper'.

What if the ECB announces a hawkish taper?

• A hawkish surprise may push EUR/USD above 1.20 levels. However, the sustainability of the gains depends on how the Italian bond markets digest the taper.
• Italy has a huge debt and is vulnerable to changes in QE program/interest rate. Reuters data shows the ECB has purchased EUR 300 billion worth of Italian bonds so far. The number is thrice of Italy's net bond issuance.
• The Italy risk is being ignored by the majority in the markets. Thus, a sharp rise in the Italian yields could catch markets off guard, leading to a drop in the single currency.
• EUR bearish scenario - A spike in Italian bond yields following hawkish/dovish taper announcement could weigh over the common currency.

EUR/USD

Daily chart

• Falling tops formation, multiple failures at the 50-DMA hurdle suggests the spot is likely to drop to the head-and-shoulders neckline level of 1.1660.
• The losses could be extended further o a dovish taper, but the downside is likely to be capped around the 1.16 handle, unless the ECB shocks market by keeping the status quo.
• A break above the 50-DMA today and a rally to 1.20 levels in the next couple of days looks likely if the ECB delivers a a hawkish surprise.

EUR/JPY  - Best candidate to play hawkish ECB QE taper

The yen is a sitting duck as Abenomics prevailed (Abe won elections) and the consensus is building among the BoJ policymakers that the policy needs to remain accomodative in order to counter the impact of the 2019 tax hike.  

Hence, EUR/JPY could rise sharply if the ECB surprises markets with a hawkish taper. As of now, the currency pair is chewing through offers around 134.28 (61.8% Fib retracement of Dec 2014 high - June 2016 low).

Daily chart

The above chart shows-

• Bullish continuation pattern - Bullish flag and pole breakout
• The 14-day RSI is in the bullish territory, and sloping upwards

There is enough room for the pair to test 136.23 (Feb 2014 low). On the downside, the weekly 10-MA level of 132.22 could be put to test on dovish taper, while the pair could drop to the weekly 200-MA lined up at 130.26 if the Italian bond yields spike following the taper announcement and the Catalan crisis worsens.