The ECB disappointed investors in December and the resulting EURbounce could complicate its task of lifting the Eurozone (core) inflation.
There is a method in Draghi’s apparent ‘madness’, however. Indeed, similar to the SNB and the RIksbank, the ECB will continue to lean aggressively against unwarranted FX appreciation while preserving ammunition for the future battles of the global currency war.
There is a method in Draghi’s madness:
To start with, we think that the ECB will welcome a weaker EUR but we doubt that an excessive FX depreciation from current levels is part of the Governing Council’s objective. In particular, we note that the ECB is now focusing more on the core rather than the headline inflation. The former is responding more slowly than the latter to moves in the single currency or, for that matter, any external price developments. Indeed, according to ECB staff estimates, a permanent 10% drop in EUR NEER could lift core CPI modestly or by c.55bp in three years.
The extended time lag between policy implementation and the realisation of the desired economic outcome adds to the significant uncertainty hanging over the effectiveness of the ECB’s policy measures. To make matters worse, the global currency war continues with central banks around the world and most notably in Europe doing their best to cheapen their national currencies.
As a result, the Governing Council may have to do more just to make sure that the pronounced EUR-depreciation we had in recent years is sustained. Needless to say, other, more important, inflation drivers like the Eurozone’s still significant labour market slack should prolong the period of subdued core inflation (Figures 3 and 4).
We remain bearish on EUR/USD and expect the pair to depreciate towards the 2015 lows and drift lower still in the coming mongths as demand for EUR-funding from abroad intensifies.
We expect EUR/USD to extend its grind lower from here. We think that growing demand for EUR-funding and EUR-funded carry trades should remain the main driver of the pair’s weakness. Indeed, we expect that foreign borrowers will continue to exploit the very attractive funding conditions in the Eurozone and issue EUR-denominated debt. They will also remain the primary sellers of EUR in the global markets. We see that as a structural shift away from the more expensive USD-funding and into EUR-funding.
At the same time, we see less scope for policy divergence to push EUR/USD much lower from here. Indeed, the ECB is less likely to engage in aggressive depreciation of the currency. We also think that too many USD-positives are in the price and doubt that the Fed can exceed already hawkish market expectations next week.
‘This content has been provided under specific arrangement with eFXnews.’