There Will Be Value In Fading EUR/USD, But Only Above 1.10

Includes: ERO, FXE
by: Tim Clayton


The euro’s funding-currency role will remain pivotal for near-term direction.

The ECB’s interests will be best served by measured optimism surrounding the economic outlook.

Draghi overall is likely to be less dovish than expected this Thursday.

Euro gains on more balanced ECB rhetoric would reverse on improved risk appetite.

Although it is unrealistic to expect the same fireworks seen after December's ECB decision, especially as there is very little chance that interest rates will be changed at this meeting, there will still be a very important impact on market sentiment. The Euro's increasingly dominant role as a funding currency will complicate both President Draghi's stance and the market reaction. A very dovish outlook would weaken the Euro initially, but quickly prove counter-productive as the Euro would bounce back on deteriorating global risk appetite. A message of cautious optimism over growth and credit would be more effective in underpinning confidence and boosting capital-market sentiment.

President Draghi's press conference will again be extremely important, especially given the bank's extensive use of forward guidance over the past two years. At October's press conference, Draghi made the important comments that monetary policy would be re-examined at December's meeting with a very clear suggestion that policy would be relaxed further. It was this commitment that triggered sharp Euro selling.

The structure and timeline for forward guidance is now even more important since the bank cut the number of meetings to 8 per year from 12 previously. Draghi has been very careful to flag policy changes ahead of time and he is likely to continue this pattern. No hints of action at this month's meeting would strengthen expectations of no change in March. If March is passed-up, there would not be another opportunity to relax policy until the second half of April.

As far as data is concerned, the latest headline inflation data was confirmed at 0.2% for December with the core rate at 0.9%. M2 Money supply growth edged lower to 5.1% in the year to November from 5.3% while M1 growth was at 11.2% and the rate of loan growth to households edged higher to 1.4% from 1.2%.

The latest bank lending survey reported further improvements in borrowing conditions for businesses and an easing of standards for housing loans while demand for loans had increased across all categories. In short, despite headwinds from the banking sector, the aggressive monetary policy is having the desired effect. It will be very important for business and consumer confidence to be sustained if there is to be a virtuous cycle of improved conditions and sentiment.

The ECB and Draghi will certainly be concerned over the risk of fresh deflationary pressures from falling energy prices and imported deflationary pressures from predatory pricing, especially from China. He will certainly be extremely anxious to avoid any further traction for a deflationary mindset. In this context, the message that the bank will take further action if necessary is likely to be reinforced, especially to avoid being boxed in.

Draghi, however, faces a tough balancing act and is likely to be more circumspect in his remarks, especially with the aggressive rhetoric and unofficial briefings into December's meeting seen to backfire as the Euro rallied sharply. Given splits within the ECB, there is little merit in another attempt at steam-rolling the wider ECB council into submission as there would inevitably be a strong backlash from German representatives.

An overly negative stance on the economic outlook would also further undermine internal and external risk appetite. Paradoxically, given the Euro's crucial role as a funding currency, a heavy dose of pessimism would tend to strengthen the Euro as carry trades and shorts would be scaled back. Euro-zone lending is also still being curtailed by retrenchment and capital-raising within the banking sector. A generally negative outlook would also reinforce retrenchment pressures and tend to curb credit growth. In this context, a relatively upbeat assessment would be more effective in meeting overall ECB objectives. Draghi is likely to be more subtle in his dovish rhetoric and look to preach a message of measured optimism.

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