Last week, Mario Draghi, head of the European Central Bank (ECB), announced something we expected, but at the same time set new ground for a major central bank. The ECB set rates into negative territory and the euro dipped at first then reversed sharply and climbed higher.
The bank announced that it was cutting its deposit facility to -0.10 percent. It had been at zero. The ECB also cut its main rate to 0.10 percent. Finally, it cut its marginal lending rate 35 basis points to 0.75 percent.
On Friday, the EUR/USD was trading around the level it was at before the announcement, on Thursday. For the week, it was up 0.1 percent, and is up 0.4 percent since its three month low. This level was set back on May 28. The EUR/USD was at 1.3644 on Friday, and at 1.3661 on Thursday. We are just at that 200 DMA, which indicates either a bullish or bearish move. Please refer to the below chart created on my Meta Trader 5.
What is causing this phenomena, which left many of us scratching our heads? Investors, those seeking higher yields, are rushing into riskier euro denominations in the Forex market. For example, they are looking for higher yielding equities and bonds. For now, the euro will continue to rise, but there are many of us betting it will weaken once again, which is something the ECB needs to happen now. If we look at the futures markets, those who are bearish wagers are more than those who are bullish. This is at its widest margin in over 10 months.
The ECB needs the euro to weaken in order to avoid falling into the very deflationary trap it wants to avoid. A higher euro will not help the dangerously low inflation rate, nor will it help the single currency zone maintain its competitive edge with exports. The bearish investors are expecting, or hoping that, the ECB will start a fresh asset purchase program (quantitative easing) that will inject money into the system. This, in theory, should push the EU currency lower. At his Thursday press conference, Draghi left the door open for this. However, he said rates were unlikely to go lower anytime soon. This pushed the euro higher.
On the other side of the pond, money managers as well as investors are gearing up for the U.S. Federal Reserve (Fed) to normalize policy within the next year. We expect the Fed to raise rates sometime in mid-2015, or sooner if the economy continues to gain momentum and strength. This divergence should also out downward pressure on the euro. As the U.S. economy continues to improve, look for the dollar to rise a bit and push the euro lower.
There is also a feeling that these measures are not enough. The ECB brought a butter knife to a gun fight. At first glance what the ECB did looks good. Lower rates, especially that negative bank deposit rate, makes the euro look unattractive to investors. Some traders like to borrow in a low interest rate environment in order to buy a higher yielding currency. They do this to make profits in carry trades. However, these ultra-low rates also put a burden on the appeal for the riskier assets within the EU. Investors are looking to go towards assets with higher returns. This has also attracted international investors looking to profit from the rising prices and, for now, supported the euro price.
This is evident in the eurozone bond market. The periphery debt has continued to soar higher. Spanish and Italian yields are at all-time lows as price has gone up and yields have moved lower. We have also seen the stock markets moving higher. The Stoxx Europe 600 is now at a brand new high, not seen in over six years. We are also seeing capital inflows into other fixed income assets. Money managers are buying Irish and Portuguese bonds to protect against a sharp fall in the euro.
The euro will rise a bit further for now. However, expect it to decline in the second half of the year. As the U.S. economy gains steam, with anticipated strong growth during this time period, this should be enough to help Draghi and the ECB get that needed downward pressure on the euro.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.