Currencies | Oct 03 2013
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
The ECB meeting has been and gone for another month, and the biggest news is what Draghi did not say, rather than what he did say. EURUSD made a fresh 8-month high after Draghi failed to use his press conference to talk down the single currency.
Some highlights from his speech:
• Price pressures “are expected to remain subdued over the medium-term”.
• The ECB expects a “gradual recovery” in economic activity.
• Forward Guidance is here to stay; Draghi said that the Governing Council “expects the key ECB interest rates to remain at present or lower levels for an extended period of time”.
• In the longer term economic output is expected to recover at a slow pace, medium-to long term inflation expectations continue to be firmly anchored although short to medium-term price pressures are expected to remain subdued.
• On the potential for a third LTRO, he said that he is ready to take more action if needed.
• The ECB discussed a rate cut.
What the market wanted to hear from his speech and press conference:
• Is the ECB worried about the level of the euro, and could it materially impact the recovery?
• Draghi only partly clarified the question mark over a potential LTRO 3. He said they would provide support if necessary, but he didn’t say if this would depend on the outcome of next year’s stress tests…
Draghi: Seems happy with EUR for now
Overall, Draghi didn’t sound too hot, he didn’t sound too cold. He didn’t mention anything about the external environment, and did not sound worried about a potential US default, brushing off a question by saying that he did not think it was likely to happen. On the growth front, the ECB President was careful not to sound too optimistic after a continuation of positive readings in the September PMI releases. He concentrated on the slow pace of the recovery and that risks remain to the downside. Regarding inflation, which is running at a measly 1.1% in the currency bloc, he said the risks are broadly balanced.
Right now, the ECB sounds fairly content with its currency policy stance, and although he is ready to take more action if needed, he doesn’t sound like he is worried that he will have to pull the trigger anytime soon. Likewise, Draghi did not seem too worried about the weak inflation picture.
Draghi stirs the EUR bulls into action
A lot of people expected Draghi to repeat what he did back in February when he expressed his concern at the level of EURUSD, which had extended above 1.3700 at one point. After that meeting EURUSD fell more than 800 pips in 6 weeks. Even though we are close to these levels, Draghi did not engage in a discussion about the exchange rate, which acted as a green light for EUR bulls.
Watch further ECB rhetoric if EUR continues to strengthen
We believe Drgahi was more sanguine on the exchange rate this time compared to February due to the improved growth outlook. However, a strong currency could be detrimental to the fragile recovery and if EURUSD continues to extend gains towards 1.40 then risks start to increase that ECB members could come out to talk down the EUR in the coming weeks.
Italy: the end of Berlusconi and one-man politics
It wasn’t just the ECB that gave the EUR a boost; Italian PM Letta also won a key confidence vote in the Italian Parliament, which means that his coalition will live to fight another day. Berlusconi made an embarrassing about-turn and ended up supporting Letta even though he was the one who tried to orchestrate the downfall of the government. This strikes me as the last hoorah for Berlusconi and his grip on power in Italy could finally be starting to fade. Politics in Italy are changing, as the rise of the Five Star Movement shows. The era of politics dominated around one man and one personality could finally be over for Italy, which could help in much-needed economic, political and judicial reform.
In a speech before the vote, PM Letta promised reforms, a debt-to-GDP ratio of 3% and to give the IMF access to Italy. 10-year GBT yields have retreated today and are the best performer in the European space, however, for yields to remain stable Letta will have to deliver.
The outlook for EURUSD
A sanguine ECB, the Italian vote and removal of Italian political risk and a weak US ADP reading are all supportive of EURUSD strength. From a technical perspective, the EURUSD has reached a high of 1.3607 and so far any pullbacks from this level have been fairly shallow. This is a fresh 8-month high, which opens the way to 1.3640 (daily close from 1st Feb).
Where could we go next? It is no wonder that investors are getting nervous around these levels; hence we could see some consolidation around 1.36 in the near term. But, with Treasury yields still in the doldrums, the German – US yield spread has started to widen again, we may see further EUR gains on the back of dollar weakness. Thus, if the EUR can maintain a yield advantage (although German yields are actually lower than US yields, US yields are falling at a faster pace than German yields, which should be EUR negative), we could see EURUSD clear the 1.3640 level, which opens the way to psychologically important 1.40 level in the coming days.
Figure 1:
Source: FOREX.com and Bloomberg (Prices displayed on the chart might not reflect Forex.com prices)
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