• Joel

EUR at Risk of Potential Dovish ECB Surprise

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EUR hit an impressive milestone today.

For the first time in well over 2 years (pretty much back when US President Trump’s tariff war against China was just starting to get kicking, resulting in a prolonged period of USD strength), EURUSD topped 1.2000.

Albeit, the move was only brief and appeared to trigger a bout of profit taking on EUR longs, but nonetheless, 1.2000 was achieved, a move many clued in analysts had been calling for for quite some time.

In terms of what has driven EURUSD higher, the most important consideration is the USD side of the equation;

The Covid-19 pandemic saw huge demand for safe haven USD back in March, but the aggressive monetary easing response from global central banks (led by the US Federal Reserve), combined with the aggressive global fiscal response, a faster than expected economic bounce back from the initial lockdowns and, more recently, the growing notion that full-scale style lockdowns will not be returned to again regardless of the spread of the virus has undermined demand for havens (such as USD) and propelled global equities back to pre-pandemic levels (or all-time highs in the case of US tech).

More specifically for USD, the Fed cut rates to zero and implemented a huge QE programme (the rate at which the Fed’s balance sheet expanded outpaced all other global central banks combined) – thus, the interest rate advantage enjoyed by the US over most of the rest of the world’s developed market economies has thus been substantially eroded.

With the Fed to keep rates low for the foreseeable future amid its new average inflation targeting programme, USD’s appeal right now is low. As the second most liquid currency in the world, EUR is a key beneficiary of this.

Moreover, on the EUR side of the equation, one key risk has seemingly been removed; that of the potential for another debt crisis and subsequent possible Eurozone breakup.

In response to the pandemic, given the fact that different countries suffered the brunt of the virus worse than others (i.e. Spain and Italy were hit much worse than Germany and other Northern European nations), the Eurozone countries managed to agree on a common fiscal response to the pandemic, involving the issuance of joint EU debt to the tune of EUR 750bln. The move marks the beginnings of fiscal union in the EU, which many have called for as a necessary step for the long-term survival of the Eurozone project. Thus, EUR, which had been pricing in an element of Eurozone break-up risk premia, has been boosted significantly.

Risks to EURUSD

But as EURUSD climbs higher, so do new risks. Namely, the risk that the ECB may seek to arrest EUR appreciation by delivering a dovish surprise in the coming September 10th meeting.

Indeed, according to Goldman Sachs, an exogenous 10% trade-weighted EUR appreciation typically reduces real GDP and CPI each by around 1% after two years. Given recent EUR appreciation, we might reasonably expect GDP and CPI to be 0.5% lower over the next two years.

This ought to be of significant concern to the ECB, which will likely be compounded by already very soft Eurozone inflation data for August that we got today; Eurozone CPI fell to its lowest since early 2016 in August of -0.2% Y/Y, well below the ECB’s “close to but just below 2% target”.

This soft CPI data couples with a broad slowdown in the Eurozone recovery seen in August, as indicated by softer busines survey data (PMIs).

Pretty much, though we have had no indication from the ECB that further easing is to come, the above factors more than justify action.

Further expansion of the PEPP (the ECB’s pandemic emergency purchase programme, implemented to combat the economic impact of the Covid-19 pandemic) would be the most likely action, though as indicated by ECB’s Schnabel recently, further rate cuts are a possibility, as, I imagine, are further easing of the terms of the bank’s long-term refinancing operations (the TELTROs and PELTROs), designed to get bank’s lending.

If the ECB does signal that a dovish surprise is on the way, this could take the wind out of EUR’s sails. Likely, it will not be enough to reverse the rise from 1.1000 witnessed in EURUSD over the past few months, as USD weakness is likely to remain pervasive.

But it could be enough to trigger EUR underperformance vs its other G10 peers. 

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