Is The ECB Done Easing And What Does It Mean For EUR?
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President Mario Draghi's remark during the ECB press conference yesterday that the bank is done cutting rates for now sent EUR soaring and European stocks and bonds tumbling, completely undoing the impact of the aggressive easing measures announced earlier. While Draghi later tried to qualify his comment, its impact seemed to linger. We suspect that the ECB officials will highlight in coming days that the bank can ease aggressively further and that the markets have misinterpreted its forward guidance. This could help prop up the European stocks and bonds and undermine the EUR. What worries us, however, is the aggressiveness of the market reaction to what could be described as an unfortunate mistake by the usually infallible ECB president. Indeed, the response reflects the growing market concern that the ECB (like other global central banks) has reached the limit of its ability to provide stimulus. A similar worry sent risk assets tumbling and JPY rallying by 8% after the BoJ cut rates below zero at its January meeting.
The risk, therefore, is that the EUR will extend its advance, especially if risk sentiment struggles to recover. Draghi’s remark on the ECB rate outlook may have had a disproportionately greater impact on EUR, given that negative deposit rates are usually seen as the main tool to cheapen the currency. In addition, during the press conference, Draghi surprisingly made no reference to past EUR appreciation as a driver of the Eurozone disinflation. The president was also at pains to highlight that the ECB is not part taking in any global currency war. Last but not least, in their quarterly forecasts update, the ECB staffers surprisingly revised up their projected path for EUR NEER to signal appreciation over the forecast horizon that will unwind a considerable portion of the sharp currency losses from 2015.
Taken as a whole, the uncertain outlook for further ECB rate cuts, the relegation of the EUR's role as driver of inflation in the Eurozone (consistent with the message from the January minutes) and the efforts to steer clear of any hint of competitive devaluation would suggest that the ECB may have shifted its focus away from EUR and towards other levers to support growth and inflation in the Eurozone. This need not mean that the Governing Council will tolerate unwarranted FX appreciation – essentially, EUR/USD rallying above 1.15. It could suggest, however, that the ECB will increasingly rely on ‘cheap’ verbal intervention rather than ‘costly’ rate cuts to lean against stronger EUR.
What does this all mean for EUR? The single currency should continue to benefit from further unwinding of market shorts.We doubt that a sustained rally towards 1.15 and beyond in EUR/USD is likely, however, given the threat of (verbal) intervention. We also do not think that the global risk aversion is as acute as it was at the start of the year. Indeed, improving data out of the US but also the Eurozone should help contain fears about imminent global recession and support risk assets. The new ECB easing measures should also help create a favourable backdrop for risk-correlated assets and thus erode the appeal of the safe-haven EUR. More constructive Fed message next week could also encourage front loading of rate-hike expectations that should support USD and weigh on EUR/USD.
Longer term, we still think that the portfolio and funding flows we will see on the back of the ECB easing measures should be EUR negative. Indeed, the combination of further ECB easing combined with indications that the bank would consider risker asset as part of its purchases could boost Eurozone demand for EUR-denominated bonds issued by non-residents. The ECB purchases of corporate debt in particular will widen the wedge between the yields of EURdenominated bonds issued by residents and those issued by non-residents. The latter assets will become even more attractive for the Eurozone investors starved for yield after repeated rounds of QE and rate cuts. In the past, the foreign borrowers sold the EUR proceeds from the debt purchases and converted them into USD to repay expensive USD debt. The latest ECB measures will only strengthen this trend, in our view, keeping EUR/USD under pressure over long term.
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