In what is becoming a familiar market situation (think the Fed circa 2013/2014) the ECB has the unenviable task of starting to repeal some of the monetary stimulus it has dished out over the last decade — without the market jumping to wild conclusions about its medium-term intentions. What is clear from recent price action over the last 24 hours is that we could see some out-sized moves in EUR/USD, up over 1.5% in less than 24 hours, relative to fundamental explanations, especially as we come into the summer months, which is historically characterized by lower volumes and higher volatility.
For what it’s worth, we think it’s always worth reminding ourselves of the ECB’s key criteria for judging monetary policy when headline inflation overshoots. The four principal questions are: the policy horizon should be judged over the medium-term, inflation should be self–sustaining, should not be temporary and similar across the whole of the Eurozone.
So which boxes can we tick? On Tuesday, Draghi said that some central-bank support will have to remain in place as the rise in inflationary pressures was "not yet durable and self-sustaining." He went on to say there needs to be persistence and prudence in the ECB’s future policy path when adjusting for improving economic conditions. We note that the pace of wage growth is still fairly moderate and uneven inflation is prevalent across the continent. In addition, one of the ECB’s favorite gauges of inflation expectations is still way off target at 1.81%.
That said, the market's reaction has been pronounced and EUR/USD is now touching overnight highs around 1.1381, getting a boost from Carney’s apparent ‘volte-face.’ It has also ignored an ECB source story saying the market has overreacted to Draghi’s comments. When a market is caught off guard, the focus turns to the general bullish assessment of the Eurozone recovery and there's no doubt that many market participants have gone into overdrive over Draghi's use of the word ‘reflationary.’
Thiat potential move toward tapering in September will of course also help the ECB’s euro bond-buying program as it’s only a few months away from reaching its limit in German bonds. In essence, many believe the central bank's intimation that the removal of accommodative policy is finally on its way, the low-volatility environment notwithstanding.
As for EUR/USD, it’s very hard to argue against price action, near-term. Having range-traded between 1.11 and 1.13 for the past 6 weeks, we smashed through the 1.13 level on Tuesday, breaking to new 2017 highs. Wednesday saw bullish consolidation, which indicates solid support on dips going forward. Trend indicators are bullish and in this scenario, any correction should be shallow while holding above 1.13. A measured move indicates trading to 1.15 in the medium-term with multi-month highs around 1.1425 along the way. The market is certainly not blinking at Draghi's comments.