Will ECB Help Or Hurt Euro?

Will the ECB Help or Hurt the Euro?

The European Central Bank’s monetary policy decision Thursday is one of the most important event risks for the FX market this week. For the past 4 trading days, EUR/USD has been confined within a narrow 100-pip range between 1.3477 and 1.3573, making the currency pair prime for a breakout. Central bank rate decisions are the perfect catalyst for big moves even if the ECB does not change interest rates. Every month the head of the ECB delivers a press conference where he provides his latest economic and monetary policy outlooks. Mario Draghi’s comments almost always move the euro as traders express their enthusiasm or disappointment with the central bank’s views. The euro dropped to 1 month lows in January after he strengthened the ECB’s forward guidance by saying “interest rates will remain at present or lower levels for an extended period of time,” and they would “act if the inflation outlook worsened” or “money markets tightened.” At the time, he ignored the improvements in German data and continued to describe the economy as weak. Since then we have seen further improvements in the Eurozone economy but as shown in the table below inflation continued to ease in the month of January. So while the ECB could cut interest rates again or introduce another LTRO, there is no immediate need for them to do so.

The ECB made it clear that inflation and the money markets are the triggers for easier monetary policy. Money markets have been stable with Eonia rising only marginally last month. Inflation on the other hand has fallen and this decline supports the case for additional policy action. Yet with economic improving, at worst, the ECB will be dovish. The chance of easier monetary policy this month is next to zero. The question of whether Draghi’s comments will help or hurt the euro depends on whether he acknowledges the recent economic improvements in the economy or ignores them again. Having only strengthened their forward guidance last month, the central bank will be wary of sounding overly optimistic and risk driving rates higher. The odds favor euro negative comments from the ECB but most market participants expect the central bank to be dovish so any hint of optimism could send the euro sharply higher. However if they are sufficiently dovish, then the divergence between ECB and Fed policy should keep EUR/USD under pressure.

Dollar Fails to Benefit from Stronger ISM

The U.S. dollar ended the day virtually unchanged against most of the major currencies. It traded slightly lower versus the euro and Japanese Yen but strengthened versus the Australian and New Zealand dollars. Stronger service sector activity failed to support the greenback. Having initially traded higher on the back of the non-manufacturing ISM index, USD/JPY gave up all of their post data gains quickly. U.S. stocks also sold off shortly after the release, hitting fresh year to date lows but recovered all of its losses by the end of the North American session. Despite the decline in manufacturing activity, service sector activity accelerated in the month of January and more importantly the employment component rose to its strongest level since November 2010. With companies in the service sector adding jobs at a faster pace, a rebound in non-farm payrolls is a certainty. However based on the price action of the U.S. dollar after this morning’s release, investors are uncertain about the magnitude of the increase. Given the slowdown in job growth reported by private payroll provider ADP, non-farm payrolls growth could still fall short of the market’s 182k forecast. Investors are worried that the U.S. recovery is losing momentum with the problems exacerbated by the Federal Reserve’s taper policy. Markets can sell-off on good news when market participants eye the data with caution and this skepticism is fueled by the negative impact of inclement weather. The Northeast is being hammered by more snowstorms and if recent data can be a guide, the storms can have a temporary but notable impact on the economy. Meanwhile Federal Reserve President Plosser, who is also a voting member of the FOMC this year said he expects the unemployment rate to drop to 6.5% “pretty soon” with an eventual drop to 6.2% by the end of the year. Interestingly enough, even though he is one of the most hawkish members of the central bank, he doesn’t favor lowering the 6.5% threshold.

GBP: No Changes Expected from BoE

Like the European Central Bank, the Bank of England is widely expected to keep monetary policy unchanged. However unlike the ECB, the BoE provides no details when they do so which should make their rate decision a non-event for the currency. Yet the recent deterioration in manufacturing and service sector activity will make policymakers more comfortable with their bias to ease. Like the U.S., the unemployment rate in the U.K. is quickly approaching their predefined threshold. If the economy were improving, they would be hard pressed to tighten monetary policy but the recent pullback in data buys them some time. For the second month in a row, service and manufacturing activity slowed, dragging the British pound lower. According to our colleague Boris Schlossberg, “In UK the PMI Services report printed at 58.3 versus 59.1 eyed and a bit lower than the 58.8 reading from the month prior. New business reading slipped below 60, employment rose to 55.6 from 55.2 and the expectations component rose to 74.3 from 73.5. Overall it was decent report that indicates that the UK recovery remains on pace, but the markets were disappointed with the rate of change in growth, which has slowed over the past several months. After hitting a high of 62.5 in October the UK Services PMI report has declined every month since confirming the thesis that UK economic recovery may have peaked in Q4 of last year. The current reading puts the UK GDP growth for Q1 at 0.8% – which is a marked improvement from the year prior but not enough to jolt the BOE into a more neutral monetary posture.”

AUD: Holds Onto Gains

The Australian and New Zealand dollars traded slightly lower against the greenback but held onto most of the prior day’s gains. The general sense of uncertainty in the financial markets is weighing on these currencies but we believe that given the RBA’s recent shift in bias and the healthy employment numbers from New Zealand, both currencies are poised for further gains. The rally in the Australian dollar is supported by the rise in service sector activity. The PMI services index surprised to the upside, rising from 46.1 to 49.3 in the month of January. Wednesday, the trade-balance and retail-sales reports were scheduled for release. The drop in manufacturing activity points to the possibility of a wider trade deficit but the increase in the sales component of PMI services suggests that retail sales could surprise to the upside. Further improvements in Australia’s economy will accelerate the gains in AUD/USD as traders continue to unwind their short positions. As we mentioned in yesterday’s note, we expect another 4 to 6% rally in the currency because there is still a significant amount of position adjustments that need to occur. No economic reports were released from New Zealand aside from yesterday’s strong labor market data. The sharp decline in Canadian building permits did not have much impact on the loonie, which held steady against the greenback. Building permits dropped for the second month in a row, highlighting the risk of a more significant slowdown in the housing market. The CAD will be in play over the next 24 hours with the IVEY PMI and trade balance reports scheduled for release. Healthier numbers are expected all around.

Yen Crosses Hampered by Market Uncertainty

While the Japanese Yen traded higher against all of the major currencies Wednesday, most of the Yen pairs including USD/JPY ended the North American trading session well off its intraday lows. This recovery was also seen in U.S. stocks and bond yields which makes it consistent with an overall improvement in risk appetite. Japanese stocks recovered after taking a bloodbath on Monday as economic data continues to highlight the improvements in Japan’s economy. Labor cash earnings rose 0.8% in December, up from 0.6% the previous month. Higher wages is an essential element in the government’s plans to beat deflation. The Ministry of Finance’s weekly portfolio flow report was due for release Wednesday evening but Yen traders seemed more interested in Bank of Japan Deputy Governor Iwata discussion with business leaders. With no major Japanese economic reports scheduled for release Thursday, risk appetite and U.S. data (trade balance and jobless claims) will determine how the Yen trades. 102 is the level to watch in USD/JPY.

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