Markets have confirmed what we suspected, the massive move higher witnessed in the wake of the ECB press conference was unjustified.
The euro exchange rate complex has given up much of the gains made during and after the ECB press conference.
Markets may have been ‘trigger-happy’ in their desire to buy the euro having heard ECB President Mario Draghi seemingly dismiss the prospect of further interest rate rises.
“Draghi's throw away comment at the ECB presser in which he suggested that negative rates have reached their downside limit, caused a massive short covering rally in the euro which spiked four big figures off its lows. The market however grossly overreacted as Mr. Draghi cleared meant that under current conditions no further move to negative rates would be necessary,” says Boris Schlossberg, Managing Director of FX Strategy at BK Asset Management.
The ECB’s cut to interest rates means the euro is now even cheaper to borrow, in fact the Bank is effectively paying commercial banks to borrow money from them.
As we argue here, the desirability to borrow euros and invest them elsewhere has grown substantially. This will ensure euros are sold on FX markets to buy other currencies to fund these investments.
This is known as the ‘carry trade’ and after yesterday we would expect this dynamic to step up a gear.
It also means that when stock markets are rallying, the euro will likely suffer, so watch for this dynamic going forward.
“Our initial thoughts are that yesterday’s price action was a bit of an overreaction and we think that risk sentiment will fare well over the coming weeks once the dust settles,” says Viraj Patel at ING.
Outlook for the Euro
ING’s Patel says the portfolio rebalancing channel of the ECB’s QE policy should in theory be (a) positive for risk appetite/liquidity and (b) slightly negative for the EUR, but any downside is now likely to be more drawn out.
“We retain our view that the pair will drift back to 1.08 in 1M, though a greater onus will be on the USD side,” says Patel.
CitiFX reckon the euro is a sell on strength, echoing a strategy that has been popular for some time now.
“EUR and euro rates appear to have significantly overreacted to selective parts of the ECB
commentary,” say analysts in a client brief, “is no denying that the ECB has over-delivered on the stimulus front and the medium term outlook is now a firm ‘sell on rallies’ to levels approaching 1.1300.”
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