Euro traders are taking profit ahead of the European Central Bank’s monetary policy meeting. As we had warned previously, concerns about Mario Draghi’s comments on the currency could lead to unwinding of long euro trades ahead of Thursday’s meeting. Many politicians in Europe have voiced frustration with the recent rally in the EUR/USD because over the past 2 months, the euro appreciated more than 7% against the dollar from a low of 1.2660 to a high of 1.3710. As an export dependent region, a strong currency crimps exports and growth. For many countries, especially the ones that have sought bailouts, any ounce of growth needs to be protected vigorously. However despite complaints from the head of the Eurogroup to French President Hollande, the euro continued to rally because investors understand that the ECB is the one agency with the power to stop the currency’s uptrend. The ECB controls monetary policy and decides if and when currency intervention is necessary. If they are worried about the level of the euro, investors should be as well but if they express no concerns, it would be a green light for further gains in the currency.
Zero Chance Draghi will call the EUR/USD move Brutal
When the ECB last met in January, Mario Draghi said, “so far, both the real and the effective exchange rate of the euro are at their long-term average.” At the time the EUR/USD was trading at 1.31 and is now trading around 1.35. This morning the German government said the currency is not overvalued at its current level and the appreciation actually shows confidence in the euro area. We expect the ECB to have a similarly nonchalant attitude about the currency as long as it remains below 1.38. In fact we think there is ZERO chance Draghi will call the euro move “brutal,” which was the harshest language his predecessor Trichet ever used to describe the move in the euro. Back in 2004 and 2007, using the word “brutal” was Trichet’s way of telling the market that if the EUR/USD were to rise any further, the ECB would intervene in the currency. Even if he were to say it was brutal, in 2007, the EUR/USD as shown in the chart below dropped 200 pips but the sell-off did not last or longer than 24 hours before the pair rallied once again, making new highs weeks later before finally topping out after Trichet criticized the move for the second time in one month. The same was true in 2004, where the EUR/USD topped out but that didn’t happen until 2 months after the ECB called the move brutal.
Instead of saying that he does not welcome “brutal moves” in exchange rates, Draghi could say excessive moves are unwelcomed, a phrase that Trichet used in 2008 when the EUR/USD was trading at 1.53, 2010 when it was at 1.34 and 2011 when it was at 1.40. Unfortunately as shown in the chart below, this had even less impact on the euro than the word brutal. This reaction in the EUR/USD should not be a major surprise because usually fundamental drivers have driven currency to those levels and its hard for the central bank to fight against the overall trend.
Data Shows Germany Continuing to Carry the Region on Her Shoulders
Since the last monetary policy meeting in January, we have seen stronger service and manufacturing activity in the region. The problem however is that Germany is once again carrying the Eurozone on her shoulders. Most of the improvements in economic activity have been in the Eurozone’s largest economy. France, the second biggest economy in the region endured a deeper contraction in service and manufacturing activity during the month of January along with stagnant consumer spending. While stronger German growth can mask weakness in other parts of the Eurozone and provide peace of mind for the ECB, we wonder how much long the central bank can ignore weakness in smaller more vulnerable countries.
ECB Firmly On Hold
Interest rates are expected to remain unchanged and Mario Draghi will most likely remind us that monetary policy remains firmly on hold. For the most part, with the tail risks removed and funding conditions returning to normal levels, Draghi will remain satisfied with the stability in the financial markets. We don’t expect any major changes to his overall view on the economy. While the ECB is done with easing monetary policy, they also have no plans to exit immediately. Draghi has thrown the ball back into the court of European governments, saying that reducing unemployment is their responsibility. In other words, the ECB is no longer in crisis fighting mode because the battle with the financial markets have been won. The markets have stabilized and the worst is over but monetary policy needs to remain accommodative because growth is weak.
We expect the EUR/USD to recover after the ECB meeting but gains to be capped below 1.40.