The European Central Bank (ECB) is about to make a key policy decision. Many expect that interest rates will stay the same. Bank of America thinks there will be small changes in the ECB’s statement. President Lagarde is likely to discuss the US-EU trade deal and the growing economic risks since last summer. Lagarde is expected to emphasize flexibility instead of making firm promises about future actions. Currently, traders expect around 7 basis points of rate cuts by the end of this year and about 17 basis points by June 2026. However, Bank of America believes these cuts could be smaller because of challenges in eurozone growth and stricter financial conditions.

Foreign Exchange Reactions

In terms of foreign exchange reactions, Bank of America sees a small downside risk for the euro after the meeting. They predict the euro may weaken against the pound and the Australian dollar. However, they believe the overall effect on foreign exchange from this week’s meeting will be limited. After yesterday’s ECB meeting, the decision to keep rates unchanged was expected. Now, President Lagarde’s cautious tone is the main focus. Her comments about rising economic risks and the need for flexibility indicate the careful approach we predicted. The market has responded by slightly increasing bets on a rate cut before the year ends. This dovish sentiment appears to be a reaction to slowing growth. Recent data shows Germany’s industrial production fell by 0.5% in July 2025. Although Eurostat’s early estimate for August revealed headline inflation dropping to 2.1%, core inflation remains steady at 2.4%. This creates a challenging situation for the central bank. We need to keep an eye on this tug-of-war between slowing growth and ongoing inflation. Given Lagarde’s repeated emphasis on “flexibility” and not making firm commitments, we believe implied volatility for EUR assets will stay high. Traders should think about strategies to take advantage of this uncertainty, as the central bank is allowing room to adjust based on new data. This is quite different from the clear guidance we had in 2023 and 2024.

Divergence in Central Bank Policy

The differing policies between central banks make short EUR positions against the pound and the Australian dollar particularly attractive. The Bank of England is signaling a “higher for longer” approach to fight its own inflation, creating a noticeable policy gap. Options traders might consider buying puts on EUR/GBP or setting up bearish risk reversals to prepare for further declines. While the market has already raised its expectations for a rate cut, now anticipating about 15 basis points of cuts by December 2025, we see potential in betting on an even more dovish path. The risks to growth seem more serious than what current rates suggest. This makes interest rate swaps that pay a fixed rate in exchange for a floating rate look appealing. History shows that during the 2011-2012 period, markets often underestimated the ECB’s willingness to cut rates in a slowing economy. Create your live VT Markets account and start trading now.

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