ECB Hits EUR As U.S. GDP Piles On

The European Central Bank killed any chance of a euro rally today after they slashed interest rates by 25bp to 0.25% and extended their fixed rate allotment to 2015. The market was caught completely off guard because less than 10% of economists anticipated the move and an even smaller amount of investors were positioned for lower rates. So when the announcement was made, the EUR/USD dropped like a hard rock through 1.35, 1.34 to test 1.33. The currency pair has bounced off the last big figure since then, but the combination of a dovish ECB and stronger U.S. data should keep the EUR/USD rebound capped below 1.3450 and the currency on its way to test 1.3225.

Deathly Afraid
Having done very little to prepare the market for the move, the ECB rate cut shows that European policymakers are deathly afraid of low inflation turning into deflation. According to Draghi, there are no signs of deflation at this time and the goal of today's move was to shorten the period of low inflation. However with producer prices declining and consumer price growth at a four-year low, the central banks knows that the euro zone could turn into the next Japan if they fail to reverse the trend of price pressures.

By lowering rates today and not in December, the ECB is leaving the door open to additional easing over the next two months. The fact that all members of the ECB felt that lower rates are needed, but not everyone believed that it was necessary to pull trigger this month tells us that policymakers could again if growth or inflation weakens further. While the ECB is running short of options, they have not exhausted all of their policy tools. According to Draghi, the ECB is technically ready to cut the deposit rate and according to previous ECB comments another LTRO is also possible.

Little Hope
When the ECB staff forecasts are released next month, we expect the growth and inflation forecasts to be lowered because the decline in inflation was stronger than anticipated and their concerns about high unemployment and weak economic conditions intensified. The central bank expects only modest growth with balance sheet adjustments, high commodity prices and market conditions weighing on activity in the months ahead, posing greater downside risks to their economic outlook. Mario Draghi made it clear that the ECB is not done easing because they haven't reached the lower bound and if the central bank is serious about preventing deflation, they will need the euro to weaken further which is why we do not expect a significant recovery in the currency.

Stronger than expected U.S. GDP growth also added pressure to the EUR/USD. The U.S. economy expanded by 2.8% in the third quarter up from 2.5% in Q2. Economists expected growth to slow to 2% but weaker consumer spending was offset by strong inventory buildup. The consistent improvement in U.S. data raises the odds of earlier tapering by the Federal Reserve. With the gap between U.S. and euro zone monetary policies only expected to widen over the next four or five months we are looking for a deeper slide in the EUR/USD and more specifically a test of 1.3325.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.