- Mario Draghi directly indicates the euro is too high for the ECB's inflation targeting.
- The euro responds in a move suggesting a ceiling has finally occurred.
- A change in the character of euro trading will likely distort a key trading signal with the U.S. dollar index.
Part of my on-going thesis for shorting the euro (NYSEARCA:FXE) is that the currency is too high to accommodate the recovery that the eurozone wants and needs to see. To date, I have been surprised at how little Mario Draghi, the President of the European Central Bank (ECB), has done to try to directly divert the growing attractiveness of the euro to currency traders. I have assumed that these traders are particularly attracted to the euro as a bet against the U.S. dollar, as a very liquid alternative to the weakening Japanese yen (NYSEARCA:FXY). On March 13th, Draghi finally started to roll up his sleeves with some old (new?) fashioned jawboning to talk the euro down. He did it in a speech in Vienna to accept the Schumpeter Award. The following was his key statement:
The strengthening of the effective euro exchange over the past one and a half years has certainly had a significant impact on our low rate of inflation and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability.
This one sentence suggests that Draghi is finally ready to target lower levels for the euro…and in the process join many of his fellow central bankers in currency-tinkering as a lever for monetary policy-making. He made this statement after expressing his hope and expectation that exchange rate would indeed fall as "the real interest rate spread between the euro area and the rest of the world" also falls. Draghi's slowly growing sense of urgency came in the form of the following statement:
…the longer inflation remains low, the higher the probability of [deflationary] risks emerging. That is why the ECB has been preparing additional non-standard monetary policy measures to guard against such a contingency and why it stands ready to take further decisive action if needed. Any material risk of inflation expectations becoming unanchored will be countered with additional monetary policy measures.
On a day when the Japanese yen ruled over all currency pairs, the euro took one of the hardest hits amongst the major currencies I follow. In particular, Draghi helped the euro to fade out of a potentially important breakout from resistance at the double-top set last November/December versus the U.S. dollar.
Draghi helps the euro fade on a day when global stock markets fell in near unison
During the latest rebound of the euro, I have slowly but surely grown a fresh short position. The current fade leaves the uptrend intact, but it may have confirmed a ceiling. If the euro manages to break this topping pattern, it will be time to consider conceding to the momentum and/or increasing hedges.
Until then, an ECB-driven weakness in the euro will certainly distort the new trading signal I had found in the U.S. dollar. I last discussed the U.S. dollar as a non-confirming signal for sell-offs in the stock market during the market's brief hiccup to start the month of March. This sell-off looked like an important turning point in the market at the time. In the current market hiccup, the U.S. dollar has weakened as might be expected these days, but the reversal in the euro helped the U.S. dollar index close the day near flat. This move looks like the beginning of the end of using the dollar as a non-confirming signal, at least in the short term.
Be careful out there!
Additional disclosure: In forex, I am net short the euro, net long the U.S. dollar.