Draghi Grabs The EUR's Attention

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 |  Includes: FXA, FXB, FXC, FXE, FXF, FXY, NZDS, UDN, UUP
by: Dean Popplewell

By Dean Popplewell

Forex "volatility and volume" appear to have all been thrown out with the bath water as the various asset classes have shifted sentiment towards the ECB's outcome next week. Even geo-political and event risk are trying to be dealt with within the confines of the already established tight trading ranges, at least until investors get a better understanding of what Draghi and company are all about on June 5th.

Draghi has dropped many hints about next week's meeting and investors have not been adhering to one particular outcome just yet. Many expect the ECB is going to cut its policy interest rate and/or announce targeted liquidity measures, with a view to supporting bank lending. Others expect a mixture of the above with cuts to deposit rates and some money market liquidity measures. The problem for the EUR bear is that any or all may not be enough to weaken the single unit currency outright. All the recent open market talk seems to have set the "expectations bar extraordinary high" and whatever is finally announced next week may not be a big enough of a surprise to punish the EUR to weaker levels.

A primary reason behind the EUR's strength has been the widening gap between the Fed's and ECB's balance sheets. Many analysts expect that an end to that widening over the short term should allow Draghi to steer clear from unconventional measures, such as negative interest rates and Fed style asset purchases or QE next week. Nonetheless, until policy makers have officially won over capital markets, they are required to keep up the rhetoric, stick to cutting the refi-rate and provide in-depth details about helping the SMEs. The ECB's balance sheet has been shrinking predominately because of the Long Term Refinancing Operation repayment (LTRO), yet funding to the SMEs would reverse this quickly. Yellen and company at the Fed continue to buy bonds, which is expected to end in October. By then, they should be turning their attention to raising interest rates, something else that is suppose to favor the dollar.

Everyone and their mother agree that action is required to subdue the EUR's strength and boost lending, eurozone exports and growth. It's the reason why expectations run high for next week. A refi-rate cut alone is not enough for growth, but outstanding support for the SMEs would have a much bigger and far reaching impact on the euro-economy. Regarding negative deposit rates, it's certainly a tool that the ECB likes having in its toolkit, however, on its belt just like QE, not so much – they have never had to deal with negative rates before and have apprehensions about expanding their balance sheet. Also, a deposit rate cut is expected to have a limited impact on money-market rates.

Euro fundamental data this morning is having a limited outright effect on the currency. Technical data on the other hand is having more of an impact. For instance, German unemployment surprised by increasing +24k this month when -15k was expected. Under the current environment, with easing already expected and one-month of job data not accounting to a new trend, has not managed to sway investors fundamentally. However, technical factors appear to be aiding the USD this morning just as we head stateside. In particular, looking at US two-year yields – beginning to show signs of backing up from their recent low – appears to be benefiting the USD this morning. The EUR continues to probe below the 200-DMA and an eventual breakthrough the option protected psychological €1.3600 handle could open the door for a much bigger move lower.

Until then, lack of market conviction should keep forex interest focused on contained trading ranges.

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