Strong euro bullish sentiment in the option market, falling inflation expectations, renewed rout in global equities and the extended slump in oil prices may force the European Central Bank's president Mario Draghi to deliver a more dovish-than-expected message at the ECB policy meeting this week, Bloomberg strategists Vassilis Karamanis and Richard Jones write.

Compared to the meeting on December 3, when Draghi delivered a stimulus expansion that fell short of market expectations, the ECB this week may need to decisively re-affirm the 'all it takes' stance to ward off possibility of further euro strength and downplay fears of falling prices. 

Otherwise, the common currency could trade north of 1.10 versus the dollar and reach uncomfortable levels for the ECB amid weak risk appetite and discouraging U.S. data for dollar bulls. Euro-dollar is already nearly 4 percent higher since the last meeting, while Deutsche Bank's EUR Trade Weighted Index has risen by more than 3 percent. At the same time, option traders are most bullish on the euro in 6 years, as 1-month 25-delta risk reversal, a gauge of market positioning and sentiment, shows.

5year-5year euro inflation swap rate, a common measure of future inflation expectations, has fallen to its lowest in 3 months, and could face further downward pressure from oil prices as the end to Iran sanctions may worsen the global glut.

Price growth is already showing signs of slowing. Germany's December preliminary Consumer Price Index dropped below zero to reach minus 0.1 percent. Renewed drop in oil prices since then may put additional downward pressure on ECB inflation staff forecasts. Last week's euro-area November industrial production missed estimates, contracting more than estimate at minus 0.7 percent m/m.

Rates market doesn't anticipate strong action by the ECB soon, as another 10bps rate cut isn't priced in by mid-year, fully-priced only by autumn. Recent Bloomberg survey shows that ECB is expected to expand its QE stimulus or cut its deposit rate by June.

Note: Vassilis Karamanis and Richard Jones are FX & Rates strategists who write for Bloomberg. The observations they make are their own and are not intended as investment advice.

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