The Counterintuitive EUR Reaction; The Market Is Wrong

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Whatever it takes” seems to be trumped by politics now

Since 2011 Mario Draghi had brought iron-clad consistency to the ECB: it would err on the side of caution, would go as far as possible to reduce fragmentation in the Euro area, and the stance would be driven solely by economic conditions. Political pressure and technical constraints would always be trumped by the necessity to do “whatever it takes” to bring inflation back to an unchanged target of “below but close to 2%”. We did not get this sense of consistency this week, and our reading is that political constraints appear to now be dominating both the stance and the choice of instruments. In other words, politics have constrained the programme, which suggests to us that, in the event of another large shock, the central bank would have little ammunition left.

Lost in guidance

We have insisted several times on the importance of (forward) guidance and communication at the lower bound. Expectations are the most powerful monetary policy at this stage. Yet, the ECB job in this regard has been far from perfect, in our view. The amount of contradictions and inconsistencies we saw in today’s policy announcement and press conference leaves us more questions than answers regarding the policy reaction function of the central bank. This is not good for inflation expectations. Finally some changes in the securities lending programme The ECB and a number of national central banks have agreed to accept cash as collateral in their securities lending program; an option we highlighted previously. While the ECB acknowledging repo stresses is positive, the overall limit for securities lent against cash is set at €50bn, a relatively small number considering total Eurozone excess liquidity now exceeds €1.1trn. As mentioned previously, this small withdrawal of liquidity does not send any monetary policy signal and should have no effect on Eonia.

FX: The counterintuitive EUR reaction

We recently argued that the Euro could be on a rollercoaster ride towards the end of the year, but what has just happened has still surprised us. Who would have expected the Euro to strengthen after Renzi lost the referendum and resigned, and to weaken after the ECB reduced the monthly QE purchases?

We believe that the market is wrong, but it could take a while to be proven wrong. And in any case, in our view, the overall market bias towards USD upside is likely to continue, as fiscal policy replaces monetary policy in supporting the US economy.


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