ECB day is here. Our preview discusses a Draghi-drag vs. Top-tapering. The team at TD outlines the various scenarios:

Here is their view, courtesy of eFXnews:

The range of potential ECB outcomes is larger as the FX response will depend not only on the actual decisions taken, but also on how the market interprets the policy intent behind them. The way the ECB communicates any plan to taper its asset purchases is of crucial importance. Within this, the more markets conclude that a decision to taper is driven by a policy choice to tighten financial conditions, the more severe the reaction in EUR (strength) may be.

If the ECB takes pains to emphasize the operational and technical needs driving any need to taper, however, the FX response may remain fairly mild. In essence, if the ECB follows the Fed’s example from 2013, we would expect a relatively sharp rally in the EUR – one that might generate a sustained and durable rebound in the common currency.

Alternatively, if the ECB follows the BoJ’s lead from this year in focusing attention on the practical constraints – the scarcity issue – its LSAP faced, then the EUR may see only a moderate bounce. As these two examples demonstrate, it is not always what the policymakers do, but how they do it that matters for FX.

Finally, the ECB could seek to postpone its day of reckoning by punting any decision to remove accommodation well into next year.This may relieve some near-term pressure on markets and investors are likely to shift their attention quickly to the upcoming FOMC meeting and expectations for a rate hike amid the USD’s broad rally. This will only fuel speculation of how they may proceed in the future, however, and intensify the market’s reaction when those questions are finally answered.

This leaves the EUR in a very precarious position. We continue to target the 1.04 level in EURUSD for end-Q4, but a hawkish outcome flags obvious upside risks to this view. A hawkish outcome – even if unintended – has the potential to reverse the downtrend seen in the pair since late September. Amplifying our concerns is the current state of investor positioning. In the latest available data, the leveraged account component of the IMM data maintained a net short of 26.4% of total Open Interest. While this is not the most stretched level ever seen, it is close to points where this investor segment has covered outstanding shorts in the past.

As noted previously, however, we are a little more focused on upside risks for this pair – at least for the near term. We continue to believe that the primary trend is lower, and this is only likely to change on a particularly hawkish ECB outcome, but the risks of an impending squeeze on existing shorts looms large in our estimation.

We think the 1.0851 level should represent significant resistance to a move higher while 1.0817 is the 38.2% retrace level of the post-US election trading range. At the same time, we note that 1.0909 (50%) and 1.1001 (61.8%) are also key Fibonacci levels of this same range.