Market Flatfooted By Draghi’s Slight-Of-Hand - But For How Long?

The European Central Bank’s (ECB) surprise rate decision shocked the foreign exchange (forex) market, certainly in favor of EUR short positions. Investors had been expecting a "no rate" change announcement, at least until next month. It’s the ECB’s nature to wait for more data, including its staff’s forecast for growth and inflation, which are scheduled for publication in December. Many forex traders had wagered that this was probably the most appropriate time for the ECB to pull the trigger and they got it wrong. Instead, ECB President, Mario Draghi, and company got itchy feet and eased benchmark lending rates by -0.25%.
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Capital markets had been working on the premise that deflation risk is complicating the Eurozone's recovery. However, Draghi noted in his post-meeting press conference this morning that there is no danger of deflation, although policymakers expect a prolonged period of low inflation.

When Doves Fly

According to Draghi, pre-cut exchange rates did not play a role in the ECB’s rate-cut announcement. That said central banks from the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Bank of Canada have all been vocal regarding their respective domestic currency values. The ECB surely did not want to be left behind -- the Eurozone’s austerity programs have left the region’s economy highly dependent on exports as a source of demand, and a high exchange rate is not good for business.
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By breaking its own conservative mold, the ECB's unexpected rate announcement indicates a more proactive approach from policymakers to address the heightened concerns across Europe.

In addition to the rate cut, the ECB announced further measures to enhance its forward guidance. A couple of inserted sentences strengthened its purpose:

A reiteration that forward guidance expects to see the key rate to remain at current or lower levels for an extended period of time
The refinancing operations will be conducted at a fixed-rate and full allotment until mid-2015

The ECB's rate cut, and Draghi's dovish tones, will keep the 17-member single currency weak for a considerable length of time. The initial two-cent move down outright this morning has now penetrated some significant support levels. But will it sink back to first-quarter levels sub-$1.3000 outright? Last February was the last time that the ECB was so blatantly dovish.

The EUR should now become an increasingly attractive funding currency for the remainder of this year. Vol-adjusted carry measures indicate they the single currency "is a better funder than the USD for G10 carry trades," due to the function of lower EUR money market rates and lower EUR-cross vols (AUD and NZD are good examples).
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American Jobs Data in View

For now, and until investors are told otherwise, the Federal Reserve will continue to try to communicate that its policy will remain loose, presumably under the guise of transparency and through tapering environment conditions. That ought to keep rates low for a considerable length of time. Under this scenario, the EUR should be capable of finding support. Normally after such a big move, one needs to understand if and by how much the currency has been oversold before committing to any longer-term strategies with conviction.

Investors’ attentions will now turn to tomorrow’s U.S. employment numbers. The initial print may be somewhat ignored because of the "dirty data" being priced "out." No matter, the U.S. jobs scenario is still one of the strongest variables in the Fed's rate decision process. A negative print would give all asset classes a wild ride !

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