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Here’s What We Expect From The ECB And Euro

Published 12/07/2016, 04:31 PM
Updated 07/09/2023, 06:31 AM

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

The euro is trading higher ahead of this year’s final European Central Bank monetary policy meeting and the big question Thursday 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 its bond-buying program but instead of falling, EUR/USD skyrocketed because ECB 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 it does, 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 bought per month from 80 billion euros. There’s no guarantee that ECB will cut bond purchases, which is why if they do, EUR/USD could break 1.08. What the ECB IS expected to do is extend the soft end date of its 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 while anything longer than 6 months could see a sell-off in the currency.

The biggest struggle for the ECB right now is deciding whether it's 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 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 its asset-purchase program. So the big question Thursday is how explicit they will be about tapering.

Euro Data Points

If the ECB extends asset purchases by 6 months, keeps the size of its 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, which is why we believe the euro bottomed at 1.05.

Meanwhile, the U.S. dollar traded lower against all of the major currencies Wednesday except for sterling. There were no U.S. economic reports released Wednesday morning and no comments from U.S. policymakers. The U.S. dollar took its cue from Treasury yields, which declined approximately 5bp. Yields have been slowly moving lower after peaking at 2.449% on December 1 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.

Wednesday's weakest currency 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 MPs 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 numbers 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 Tuesday night by a surprisingly large contraction in Q3 GDP growth. Wednesday's focus 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 Thursday but Australian and Chinese trade numbers are on the calendar.

Latest comments

I love to wake up to Kathy Lien's BRILLIANT articles! Thank you Kathy for providing such an amazing service!
you should be grateful to her to let you loose money...
there are 9 if's in this article. I need a mathematician to tell me how many scenarios are embedded in this article.
thank you^^ .
thanks for detail explain.
thank you
u r the best..
Keep up the analysis! Doing good job!
Mario Draghi will disappoint and the Euro will go tremendously HIGH. Not a chance to extend the QE
Thanks.)
Thanks Kathy :)
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