Week In FX Europe - ECB Pulled The Trigger And Kept The Door Ajar

 |  Includes: FXB, FXE, FXF, UDN, UUP
by: Dean Popplewell

He did it, Draghi turned on the lights when the market least expected. The ECB cut its refi-rate by -0.25%, to just above zero on Thursday. Perhaps more importantly and because of the global benign inflation phenomena, the euro policy makers kept the downward bias to its forward guidance. In other words, the door was kept open to take euro deposit rates into negative territory.

Negative deposit rate are generally tied to a more deflationary economic backdrop, the late 90s in Japan is a good example. Europe is not there yet according to Draghi. During yesterday's press conference he indicated that there is no danger of deflation, although policymakers expect a prolonged period of low inflation.

By breaking its own conservative mold, the ECB's unexpected rate announcement indicates a more proactive approach from policymakers to address the heightened concerns across Europe. Any further downside movement from an already fragile recovery combined with weak inflation is likely to be accompanied by further ECB action now that they are in "proactive gear."

The surprise ECB cut has steepened the 5/30's curve to ten-year highs. Can this move much further? Fixed income dealers think the spread looks rich, and without negative deposit rate cuts the top could be close. However, expect risk premiums to be applied for Q1 Eonia 2014 meet.

The EUR has not backed away from it initial -1.5% fall, aided by Friday's NFP surprise. Last February was the last time that the ECB was so blatantly dovish. The EUR is expected to become an increasingly attractive funding currency for the remainder of this year. For now, and until investors are told otherwise, the Federal Reserve will continue to try to communicate that its policy will remain loose, presumably under the guise of transparency and through tapering environment conditions. That ought to keep rates low for a considerable length of time. Under this scenario, the EUR should be capable of finding some support close to the 1.3000 levels.