Further Euro Appreciation Unlikely

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Includes: DRR, ERO, EUFX, EUO, FXE, UDN, ULE, URR, USDU, UUP
by: Citylytics

Summary

The market is not entirely comfortable with the EUR/USD levels above 1.20.

Inflation is still not at a level that would prompt the ECB to change the monetary policy course.

The ECB’s meeting on Thursday provides ideal opportunity to deliver a verbal intervention.

Any further euro appreciation seems unlikely and we might even see a solid correction from the current EUR/USD levels.

Following a short surpass above 1.20, the EUR/USD is currently trading in the safe territory of around 1.19. It seems that the market is not entirely comfortable with the much stronger euro. Reuters reported yesterday that rapid gains by the euro against the dollar are worrying a growing number of policymakers at the ECB and raising the chance that the asset purchases will be phased out only slowly. The latter is in line with the latest ECB minutes from July's meeting that also showed increased concern regarding the strong euro.

Meanwhile, the euro area HICP rose by 0.3% mom in August so that through year growth rose two tenths to 1.5% yoy and thus outperformed market expectations. However, the increase was mainly driven with higher prices in the energy sector and the 'core' inflation remained steady at an expected 1.2% yoy. Although somewhat stronger, the inflation is clearly not at a level that would prompt the ECB to change the monetary policy course.

Only because Draghi did not use the opportunity at the Jackson Hole to refer to the current EUR strength does not mean that he is comfortable with the recent euro strengthening. In addition, the meeting on Thursday provides an ideal opportunity for ECB to discuss the impact of a stronger euro on growth and inflation as they will be publishing their newest macroeconomic projections. After all, the euro appreciated by roughly 6% in trade weighted nominal terms through the course of this year. Not only does a stronger euro slow exports growth but also lowers inflation through cheaper imports.

Moreover, Draghi clearly stated at Jackson Hole that the ECB has not yet achieved self-sustained convergence of inflation toward their medium-term goal of 2%. Further euro strengthening would put additional pressures on the inflation (as was the case in 2014), and for this reason, the ECB will not allow the euro appreciation to get out of hand. The ECB will probably refrain from comments such as "the euro is overvalued", but rather deliver small hints of concerns in the form of "we are closely monitoring the exchange rate". The latter will be enough to at least prevent the new euro longs and possibly even lower the EUR/USD from the current levels to approximately 1.17 in my view.

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