Euro – Here’s What We Expect from the ECB & Euro
Daily FX Market Roundup 12.07.16
The euro is trading higher ahead of this year’s final European Central Bank monetary policy meeting and the big question tomorrow is whether there will be an ECB surprise that triggers the same 4-cent (400 pip) move in EUR/USD that we saw in December 2015. Around this time last year, the ECB cut interest rates and extended the target end date for their bond buying program but instead of falling, EUR/USD skyrocketed because they failed to increase the amount of asset purchases and lowered rates by the minimum that the market anticipated. Fast forward 12 months and the market is looking to see if the central bank scales back asset purchases. If they do, we could see a massive short squeeze in EUR/USD. The move from 1.05 to 1.08 shook out some shorts but last week’s CFTC data showed significant anti euro positioning and we sense that more short covering will occur if the ECB reduces the amount of bonds they buy per month from 80 billion euros. There’s no guarantee that they will cut bond purchases, which is why if they did, EUR/USD could break 1.08. What the ECB IS expected to do is extend the soft end date of their bond buying program by 6 months. It is currently expected to end in March 2017. Anything short of 6 months and the euro could rally and anything longer than 6 months and we could see a sell-off in the currency.
The biggest struggle for the ECB right now is deciding whether it is time to prepare the market for tapering. The Italian referendum did not cause a lasting sell-off let alone a systemic crisis in the financial markets. Instead after a brief dip, European stocks and the euro soared with the single currency rising to its strongest level versus the U.S. dollar in nearly 3 weeks. To the ECB’s relief, what could have been the greatest risk for the euro this month barely caused a hiccup in the markets. According to the table below, there have been widespread improvements in the Eurozone economy. Consumer spending is up, the unemployment rate is down, inflation has improved and activity is stronger across the region. Draghi has taken every opportunity to highlight the resilience of the Eurozone economy and these economic reports explain why he’s been optimistic. Yet much of the improvement can be linked back to the weaker euro and if Mario Draghi talks tapering, the EUR/USD will soar, reducing the positive contribution to price pressures. Inflation remains very low and the ECB may not want to risk spooking investors and jeopardizing the improvements made so far. With that in mind, the ECB is running out of bonds to buy and needs to start thinking about winding down their asset purchase program. So the big question tomorrow is how explicit they will be about tapering.
If the ECB extends asset purchases by 6 months, keeps the size of their bond buying program at 80 billion euros and makes no comment on tapering (he will definitely be asked this question during the press conference), EUR/USD traders will take the currency below 1.07 in disappointment. But if Draghi shares some of the ECB’s ideas on tapering and reduces the amount of bonds purchases per month, we could see EUR/USD hit 1.09. However even if the euro sells off, we think it’s only a matter of time before the central bank announces a QE exit strategy and for this reason we believe the euro bottomed at 1.05.
Meanwhile the U.S. dollar traded lower against all of the major currencies today expect for sterling. There was no U.S. economic reports released this morning and no comments from U.S. policymakers. The U.S. dollar took its cue from Treasury yields, which declined approximately 5bp today. Yields have been slowly moving lower after peaking at 2.449% on December 1st and with no major U.S. economic reports on the calendar this week, rates could fall further into the weekend, leading to a deeper pullback in USD/JPY. We would not be surprised if the currency pair traded on the lower end of the 113 handle by the weekend.
The weakest currency today was the British pound, driven lower by Brexit news and disappointing data. The UK government accepted labor motions to reveal Brexit plans by the end of March 2017. The move by PM May was done in an effort to quell possible rebellion from Tory MP’s and to settle any possible rejection from the House of Commons. The agreement for the outline of the Brexit strategy came with a contingency of agreeing to a government-defined timeline for Brexit, which was accepted by U.K. lawmakers. Industrial and manufacturing production umbers are not usually big market movers for sterling but the huge miss caught the market by surprise. Industrial production dropped -1.3% and manufacturing production fell -0.9% against forecasts for a 0.2% rise.
All three of the commodity currencies traded higher versus the greenback including the Australian dollar which was hit hard last night by a surprisingly large contraction in Q3 GDP growth. The focus today was on the Bank of Canada’s monetary policy announcement. The BoC left rates unchanged and issued a firmly neutral monetary policy statement. They said the dynamics of Canada’s growth are largely as anticipated and current monetary policy stance remains appropriate. Business spending and non-energy exports were disappointing but infrastructure spending isn’t evident yet in GDP data. With the BoC rate decision behind us, we think USD/CAD should find a near term bottom around 1.32. Oil prices have fallen and most importantly, the U.S. – Canadian yield spread is moving higher in favor of gains in USD/CAD. There are no Canadian or New Zealand economic reports scheduled for release tomorrow but Australia and Chinese trade numbers are on the calendar.