Euro Pops Higher After Post ECB Tumble; What's Next? - Analysis

Euro Pops Higher After Post ECB Tumble; What's Next? - Analysis

10 March 2016, 21:00
Vasilii Apostolidi
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In a near replay of the tumble, then rally, seen in December, the euro Thursday moved first sharply lower and then sharply higher in response to European Central Bank policy actions.

On Dec. 3, the euro rallied 4.3%, from a $1.0524 trough to a $1.0981 peak, when the market decided the ECB's easing actions were not as powerful as anticipated.

Thursday saw the euro rise 3.7% from trough to peak, even though the ECB more than delivered in terms of market expectations.

At an event in mid-February, ECB Vice President Vitor Constancio told a New York City audience he had been "surprised" by the market's response to ECB easing in December.

Going forward, he looked for ECB members to be more cautious in their commentary so as "not to build up expectations."

In recent weeks, ECB President Mario Draghi and other members have hinted that March action was likely in their commentary, but did not offer specifics.

In the latest ECB State of Play, posted Thursday after the central bank's decision, MNI's Johanna Treeck and Martin Baccardax that after unveiling a package that "included a cut in all three key rates, an expansion of monthly asset purchases, a new corporate bond buying program and new long-term liquidity operations," the euro fell to lows near $1.0822, the lowest levels since Feb. 1.

However, "a reference by the ECB president, however, that rates may not go much lower than announced Thursday, quickly reversed the initial euro slide," they said.

At the same time however, "Draghi by no means slammed the door on further rate cuts, telling journalists that 'new facts can change the outlook', and went out of his way to stress that the ECB still had more than enough policy ammunition for future deployment," Treeck and Baccardax said. See MNI Main Wire at 12:30 p.m. ET for further details.

Traders, who either were short euros and long Bunds ahead of the decision, or entered into short euro and long Bund trades shortly afterwards, were initially happy.

However, as Draghi made his comments interpreted to mean that yields may have bottomed, eurozone yields began to climb, led by a push higher in Italian bond yields.

Soon, German Bund yields were taking out key resistance levels, causing a short squeeze in yields and the euro, where players were also caught short.

Bund yields closed on a firm note Thursday, although off earlier highs.

Ten-year yields were last at 0.306%, on the high side of a 0.157% to 0.333% range.

Today's yield high was a far cry from Feb. 29, when in response to soft flash EMU HICP inflation data, German yields fell to a low around 0.101%, the lowest level since last spring, in anticipation of ECB easing action at the March 10 meeting.

As a reminder, Bund yields posted a record low of 0.0485% April 17, 2015. On Feb. 5, 2016, when U.S. Treasury yields topped out at 1.908% (a level broken Monday and also today), Bund yields peaked at 0.326%, which was taken out earlier.

In afternoon action, the euro, currently at $1.1212, has retreated modestly after posting an intraday high of $1.1218, the highest level since Feb. 15. That day's high of $1.1261 will act as the next level of resistance.

Traders who, earlier in the day, would have favored selling EURUSD rallies towards $1.1000, now leaned towards buying EURUSD dips to $1.1100.

"I think it will be hard to get the euro below $1.1000 again," one trader said.

After posting a low of $1.0524 Dec. 3, the day of the ECB decision that disappointed, the euro closed 2015 at $1.0862.

So far this year, the pair has traded in a range of $1.0711, seen Jan. 5 to $1.1376, seen Feb. 11, at the peak of risk aversion and dollar selling.

"Given the euro's resistance to the ECB's new measures, which were welcomed at first in the euro-zone stock and bond markets (though less enthusiastically after the euro's recovery), it is tempting to think that the chances of the exchange rate against the dollar sliding to parity are now very slim," observed John Higgins, chief markets economist at Capital Economics.

However, Capital Economics maintained that EURUSD direction going forward "rests much more heavily on investors being too dovish about the prospects for Fed policy than it does on them being not dovish enough about the prospects for ECB policy."

Capital Economics forecast is that "rising inflation will prompt the Fed to raise its target for the federal funds rate to a range of 1.0%-1.25% by year-end (from 0.25%-0.5% now), whereas the implied rate of the December federal funds futures contract is currently only around 0.65%," Higgins said.

Stephen Stanley, chief economist at Amherst Pierpont, saw spillover implications for the Federal Reserve from Thursday's ECB action and market reaction.

The ECB gave the market "exactly what was expected today," but Draghi's later Q&A comments ("don't anticipate it will be necessary to reduce rates further") were interpreted "as a signal that the ECB has little or no appetite to go deeper into negative territory," went against the consensus view looking for further cuts, he explained.

The ECB may have intended to say "'after today's move, we consider our stance to be appropriate,' in which case, the statement means essentially nothing," Stanley said.

Thursday's ECB action makes it easier for the Fed to raise rates, he said.

"First, the rate differential is less of an issue than previously though ... and as a result, the Fed has slightly less reason to worry that the dollar is going to strengthen dramatically," he said.

Second, "the greater the ECB QE, the lower global long bond rates are going to be," he added.

Amherst Pierpont maintained its view that the Fed will not hike in March, "and probably not before June, unless inflation continues to surprise to the upside," Stanley said.

Also, "the ECB's actions are pretty far down the list of influences on the FOMC's thinking," he added.

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