The Week Ahead: The European Central Bank’s Euro Problem
The European Central Bank’s Euro Problem
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Andrew Kositkun Foreign Exchange Head Trader
Starting next week, The Week Ahead will transition to FX Compass. This refreshed weekly communication will continue to have the short term analysis we have always provided, but will incorporate long term views as well.
Markets have embraced a pro-risk view with fewer challenges than expected. On the vaccine front, the U.K. has become the first Western country to approve a COVID-19 vaccine, with the U.S. and EU likely to follow suit shortly. Even the political cycle, which is more of a secondary factor, has been moving in the right direction, as contested election fears have faded. This combination of overall net positive factors has contributed to a rally in global equities and boosted cyclical currencies. Included in this is the euro–U.S. dollar (EUR/USD) exchange rate that currently sits at its strongest level against the dollar since the first half of 2018, a level that is misaligned with economic fundamentals, as the European economy has underperformed this year.
Previous comments out of the European Central Bank (ECB) indicate that the bank would start being concerned about EUR/USD valuation around 1.20, or a level below where we currently are. This makes it likely that the single currency will be addressed at the ECB meeting this week. But questions remain around just how much the central bank can actually do. Complicating the ECB’s job is the fact that recent euro appreciation is more a reflection of a USD selloff and improved global risk sentiment than a euro rally.
Unfortunately, the macro data in Europe doesn’t leave much room for complacency. Headline eurozone inflation is negative, and core inflation sits at historic lows. Even with positive vaccine news, it will take time to get enough people vaccinated for a return to normalcy. Clearly, the longer the eurozone economy is subject to COVID-19 restrictions, the higher the risks for long-term economic damage.
So what exactly can the ECB do about recent euro strength? At a minimum, ECB President Christine Lagarde should repeat her language from the September meeting that reiterated the euro exchange rate as a key input to the bank’s inflation outlook. While this has paused euro moves in the past, the effect is not long lasting. What makes the ECB’s situation tricky is that its policies have offsetting implications on the euro. Monetary policy loosening is euro negative, but ECB policies such as the Pandemic Emergency Purchase Program (PEPP) support the periphery and are euro positive.
One area that the ECB can improve on is its communication. There have been several instances where ECB officials, including Lagarde herself, have had to clarify statements in the days and weeks after ECB meetings. This poor communication likely reduces the effectiveness of policy measures and has led to some of the euro’s strength this year. Another area that could help is increased clarity on life after the PEPP expires. Without the PEPP, the ECB will have to go back to the capital key and other QE constraints that limit the bank’s ability to use open-ended QE to hit its inflation target. Constraints on QE, relative to the status quo, could lead to euro strength as monetary conditions tighten. A possible solution is to find an excuse to extend PEPP, say, until forecasted inflation moves back to pre-COVID-19 levels, but this isn’t a sustainable solution. Ultimately, no easy options are currently available to the ECB, increasing the importance of the upcoming strategy policy review.
Returning the current euro strength, history has shown that central banks have had little success talking down currencies. Nevertheless, expect increased jawboning out of ECB officials over the coming weeks. Over the longer term, constraints to the ECB’s QE program will likely make it difficult for the bank to meaningfully weaken its currency.
EUR/USD sits above the 1.20 level on the interbank market in a move more related to USD weakness than euro strength. Equity inflows, an apparent peaking of the virus wave, Brexit progress, U.S. fiscal stimulus progress and vaccine optimism should continue to provide support for the euro and opens the possibility for further euro gains. On the other side, the pace of euro gains has caught the attention of the ECB. While the bank is unlikely to confirm formal intervention, current EUR/USD levels makes a recovery more difficult from an export perspective. As a result, jawboning appears to be inevitable in the coming weeks, but its effectiveness is questionable. In regard to this week’s ECB policy meeting, the bank is expected to leave rates unchanged but provide additional stimulus through other measures, including asset purchases. Additionally, the EU summit this week should bring compromise on the EU fiscal package. Expect choppy trading as resilient market optimism continues to support the euro but pullbacks are also likely given the lack of fundamental growth.
Cable moved to new year-to-date highs last week on Brexit deal optimism. There are two schools of thought on the pound, assuming a deal. The first is that a deal would send the pound soaring, as it is one of the most underweight equity markets in the world, with foreign direct investment also returning. The second is that the pound will rally on the announcement but subsequently collapse as focus changes to the U.K. economy’s poor performance and the negative implications of a skinny Brexit deal relative to the status quo. On balance, the bias here is more for the latter outcome. On the virus front, the U.K. became the first Western country to approve a COVID-19 vaccine, with the 800,000 doses scheduled to be delivered next week.
The yen remains heavy on rallies in the first full week after Thanksgiving. The bias remains for USD/JPY to move lower, so expect markets to continue to add shorts on any rally, as Japan’s real interest rate advantage supports trend strength. Notably, the fourth quarter marks a fiscal cliff in Japan, as fiscal support was concentrated in the second and third quarters. The effects of this fiscal cliff should be exacerbated by the drop in consumer sentiment from additional lockdown measures as a result of rising COVID-19 numbers. By strengthening downside economic risks, infection rates and the drop in Prime Minister Yoshihide Suga’s approval ratings should result in additional fiscal expansion.
The loonie made new lows last week, as the market optimism on global growth, OPEC+'s production agreement, a strong Canadian jobs report and USD weakness helped all cyclical currencies. We could be in for some near-term consolidation given the size of recent moves. However, longer term, the market’s positive outlook on global growth should keep the CAD supported against the USD, but domestic factors are likely to keep these gains relatively smaller than gains for other pro-cyclical G10 currencies.
The yuan (CNY) outlook remains bullish. China’s economy continues to perform, as evidenced by positive PMI data. Further, flow data shows that foreign investor demand for Chinese fixed-income assets remains strong. China’s continued performance raises the question of when the People’s Bank of China (PBoC) will change its policy stance. On this, the view remains that policy withdrawal will be incremental due to moderating CPI inflation reads and to avoid disruptive credit defaults. As such, the PBoC is likely to continue to tolerate modest CNY appreciation. The bank desires a more market-oriented exchange rate regime, and recent moves are representative of strong economic fundamentals, widening interest rate differentials and global asset-manager portfolio diversification. Additionally, the PBoC needs to exit normal FX market intervention as agreed to in the U.S.–China trade deal.
Reserve Bank of Australia’s rate decision came and went without much fanfare, as the bank kept its rate and targets all unchanged as expected. While the bank acknowledged positive developments, it also tempered optimism by pointing out expected weakness in employment. With the USD continuing to weaken as global sentiment is firmly positive, the Australian dollar (AUD) should continue to find support, but at the same time, valuation is not cheap, and trade tensions with China continue. On balance, the markets continue to give more weight to the AUD bullish case, but valuations are starting to look stretched.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
Expectations for rates to remain unchanged at -0.50% but with monetary easing through other measures
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
U.S. Initial Jobless Claims
Expectations for 723,000 claims
Expectations for a 0.1% month-over-month increase
U.K. Industrial Production
Expectations for a 0.3% month-over-month increase
Expectations for a 0.2% month-over-month increase
German ZEW Expectations and Current Situation Survey
Expectations for a 46.0 and -66.0 print, respectively
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