Morning Commentary: Lower for Much Longer

Foreign Exchange - Morning Commentary
Lower for Much Longer
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
This past week, ECB officials grabbed the market’s attention by indicating their discomfort with the euro’s appreciation.  To be sure, it wasn’t a coincidence that the ECB’s signal coincided with core inflation in the Euro area dropping to a record low and EURUSD moving back up to its historical average level. 

The fact that EURUSD is no longer cheap, in a historical sense, would likely be enough to get the ECB’s attention to the euro’s assent on its own.  But when taken in context of record low core inflation, markets are understandably interested in what the central bank might do regarding the feedback loop from the currency to inflation and policy as these potential measures could dampen euro bullishness. 

This brings us to the ECB’s meeting later this week.  While it is likely too early to expect an extension to the bank’s QE program, the drop in European inflation could refocus the market’s attention to the fact that the ECB’s QE and overall balance sheet expansion has been outpacing that of the Fed.  This result may be a surprise to some, given recent headlines around the Fed’s proactive targeting of inflation, but the ECB has actually been more forceful with its actions.  Nevertheless, the wait for further QE shouldn’t be very long as the ECB’s Pandemic Emergency Purchase Program should be expanded by yearend. 

For this week’s meeting, keep an eye out for changes to the ECB’s staff forecasts with particular emphasis on inflation.  One of the most persuasive arguments for a change in inflation assumptions is the EURUSD exchange rate that is roughly 10% stronger than assumed in the June forecast.  Even if inflation expectation aren’t lowered, the euro is unlikely to receive a boost as core inflation is stuck below 1%, meaning the ECB remains on the hook for further policy accommodation.  Moreover, the ECB is still set to announce the results of its own policy review that will likely lead to dovish tweaks similar to what came out of the Fed’s policy review. 

Much has been made of the Fed anchoring policy expectations due to its inflation framework change.  But the ECB hasn’t needed such a change for markets to price in a perma-hold.  Currently, market expectations are for the first full 25 bps ECB rate hike to come a full two years after the Fed is expected to move.  This sets out a long runway for euro bulls to run before getting some relief from negative rates.
  • US stimulus talks remain gridlocked.  Senate Republicans will push to pass a skinny bill but will need Democratic support to reach 60 votes.  While the skinny bill would restore $300/week of enhanced jobless benefits, it doesn’t include another round of $1,200 stimulus checks or state and local aid.  Based off comments from Speaker Pelosi, this skinny bill is a non-starter in the House.
  • The Bank of Canada kept its policy rate unchanged at 0.25%, in line with market expectations.  Additionally the bank confirmed that its QE program will continue until the recovery is well underway. 
  • The British pound continues to be under pressure as the EU pushes back on the UK’s plan to introduce a bill that would weaken its Withdrawal Agreement.  In essence, the critics are warning that introducing such a bill will undermine the UK’s position with other international trading partners.
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