Mario Draghi, the President of the ECB, said very clearly yesterday that currency intervention is bad, the market should set interest rates and that the ECB doesn’t have the mandate to control the single currency. Yet, since his press conference yesterday afternoon the euro is down by more than 1%. Can Draghi do for the euro what he has so far been able to do for Spanish and Italian bond yields?
This brings an interesting dimension to currency war debate. Draghi only had to hint that if the euro was to remain elevated and weigh further on inflation then the Bank may have to act to stem deflationary pressures. He didn’t say “rate cut”, he didn’t have to. Inflation in the Eurozone fell to 2% in January (according to the initial estimate), and is expected to fall below target in the coming months. This opens the door to rate cuts going forward. In contrast to the US, Japan and the UK, the Eurozone has room to cut rates, and the benchmark rate is only 0.75%, which is euro negative. Although the ECB won’t be able to make big cuts to rates the ECB is not as limited as other G4 central banks who are constrained by rates being near zero.
However, not everywhere in the Eurozone is at threat from deflation. Germany’s economy is strong and so is its labour market. The Bundesbank may not favour further rate cuts; but if the “Draghi effect” can continue to weigh on the single currency then the ECB may not have to cut rates after all, a bit like how it still hasn’t had to activate the OMT.
Has Draghi called a top in the euro?
The prospect of rate cuts or some sort of “intervention” by the ECB to stem euro appreciation could make it difficult for EURUSD to move higher from here. Draghi mentioned the 10-year moving average in EURUSD as being 1.3450, roughly where we are now. Although the ECB isn’t targeting this level, it suggests it may be uncomfortable for the Bank if EURUSD rises towards 1.40.
The prospect of rate cuts weighed heavily on the euro vs. the GBP, USD and yen yesterday; compared to these central banks the ECB has room to cut rates. EURGBP is down more than 1.5% since Draghi’s press conference, this compares with a more moderate 1.2% fall in EURAUD. The euro may hold up better against the Aussie in the medium-term because the RBA also has room to cut interest rates in future as rates in Australia are 3%. Thus, the prospect of future rate cuts could be the biggest driver for the euro in the medium-term.
While the unemployment rate is the key data release for the USD and the Fed, inflation is now the key release for the euro and the ECB. The final January CPI data for the currency bloc is released on 28th February, which will be closely watched by the market. Likewise, inflation components of PMI surveys will also be monitored to see if they point to an increase in deflationary pressure.
The key test for the euro is whether it can break its inverse correlation with Spanish and Italian bond yields. As the European financial system has healed in recent months demand for “emergency” dollar funding has fallen this has fuelled some of the renewed inflows into the euro. Likewise, flows back into peripheral sovereign bond and equity markets have also driven demand for the single currency. Thus, continued recovery in the sovereign debt crisis could be bitter sweet for the ECB if it keeps upward pressure on the EUR.
Technical view: EURGBP:
This cross looks vulnerable to a sell-off, especially after the not-so-dovish Mark Carney commentary yesterday. After forming a double top just below 0.8700 earlier this week it had a sharp selloff. It found support at 0.8520 post the ECB press conference, a break below this level could lead to another leg lower back towards 0.8400. Key risk events for this cross next week include Eurozone GDP on Thursday and the UK’s first Inflation Report of the year, released on Wednesday.