Thursday’s ECB meeting is important in the context of recent market moves and statements regarding the level of the euro. Citi notes that the rise in short-dated vol indicates considerable investor focus on the meeting. Expectations have been building that ECB President Draghi may offer a more cautious tone to ‘talk down’ the moves seen in the short-term rates and FX. In light of President Hollande’s advocation of an exchange rate policy aimed at ‘safeguarding competitiveness’, Draghi will likely face further questioning on FX. However, Citi does not believe that he will reverse his position and explicitly talk the currency down. Goldman also notes that while ‘Taylor-Rule’ users might infer a 30-50bps lowering of rates (thanks to growth, FX, and inflation) the improvement in ‘fiscal risk premium’ balances that dovishness leaving Draghi likely on hold. However, he is unlikely to stand ‘idly by’ without some comment on the ensuing currency wars.
Short-term, the LTRO repayment (and Fed QE4EVA) leaves EURUSD biased upwards on balance sheet basis…as the ratio of Fed/ECB balance sheets has now round-tripped to the start of LTRO2
though medium-term perhaps EURUSD is discounting the Fed’s expansion and ECB stability…
but EURUSD has a bearish bias based on spread differentials…
In the January press conference, Draghi stated that “[he] never comments on exchange rates”. While the EUR NEER has appreciated significantly in January, the current levels are not ‘excessive’ when compared to historical averages. The proximity to “historical averages” is something which Draghi highlighted in the January press conference. Furthermore, Hollande’s comments met opposition from German Government Spokesperson Steffan Seibert who suggested “exchange-rate policies shouldn’t be an instrument to strengthen competitiveness,’’ and viewed the euro’s rise as an indication that “confidence is returning to the euro area”. We expect Draghi to largely echo these thoughts, while stressing that the exchange rate is merely an input variable into their monetary analysis.
As our economists have written, Draghi may adopt a more dovish tone to convince market participants that monetary conditions will remain loose, but we view any specific ‘talking down’ of the EUR as unlikely. Based on the check-list of indicators from the ECB’s January press conference (CDS prices, stock market indices, realised volatility, capital inflows, Target 2 imbalances, confidence indices, current account balances), market developments are likely to be viewed as broadly positive by the ECB more than offsetting any negative impact from EUR strength. Therefore, given expectations of a dovish statement, we think risk-reward favours some short-term upside as expectations that Draghi will talk down the euro are re-priced. Over the medium term we hold a bearish EURUSD view, largely as a function of relative growth prospects versus the US but believe expectations for ECB action are slightly overdone.
There are two other important events that will likely grab Draghi’s attention:
Another important area of focus will be Draghi’s views on the impact of the first LTRO repayment. If he suggests that large initial repayment in January is a positive sign indicating stabilization, market expectations of the amount to be paid back from LTRO2 are likely to increase, which will support the EUR. Alternatively he may caution banks about returning cash too early, since the design of the operations was to provide cheap funds in case they are needed at some point in the future and the ECB will be keen to avoid another LTRO unless absolutely necessary. A reduction in market expectations of the amount of LTRO2 borrowing to be paid back will weigh on the EUR.
Another major risk event sees Spain returning to the bond market for the first time since negative headlines over Mariano Rajoy emerged last weekend. Widening periphery spreads to Germany were a driver of euro weakness on Monday and the close relationship should hold once more today. The treasury will auction €3.5-4.5bn of the SPGB Mar ’15, SPGB Jan ’18 and SPGB Jan ’29.
Via Goldman Sachs,
So how is the ECB likely to react to the recent exchange rate appreciation? Since the December ECB Governing Council meeting, the Euro has appreciated by about 3.5% on a real trade-weighted basis. Our ‘real time’ Taylor rule implies that a 3.5% appreciation would lead to a 15bp-20bp lower ECB policy rate. Combining this effect with that implied indirectly via the impact on growth and inflation, our results imply lowering policy rates by between 30bp and 50bp, depending on how much of the recent Euro appreciation reflects exogenous factors. On our current forecasts, we expect the Euro trade-weighted index to appreciate by a further 1.5% over the next quarter (with the EUR / USD cross reaching 1.40). Accounting for this further appreciation, the total downward impact on ECB rates, according to our ‘real time’ Taylor rule estimates and subject to the degree of exogenous factors driving the exchange rate appreciation, is between 45bp and 75bp.
However, we cannot hold all other determinants of the policy rate constant in this exercise. In particular, the fiscal risk premium has also moved sharply since December. And our empirical results suggest that we need to control for this effect if we are to rely on our estimated direct impact of the exchange rate on rates. Our ‘real time’ Taylor rule estimates imply that the 250bp decline in the fiscal risk premium would equate to a rise in ECB rates of around 80bp-90bp. Thus, the decline in fiscal risk would more than counter the effect of recent Euro exchange rate appreciation on ECB rates.
Hence, on our ‘real time’ Taylor rule estimates, we think the Euro exchange rate appreciation has not been sufficient to warrant a cut by the ECB, so far. Even if the Euro were to appreciate further to our forecast level of EUR / USD at 1.40, our results suggest rates would be on hold.
For all the recent talk of ‘currency wars’ and the vulnerability of the Euro area economy should the ECB ‘stand idly by’ while the other advanced economies engage in competitive devaluation, our empirical work suggests that we are still some way from an ECB policy rate cut driven by concerns about Euro appreciation.
This has the potential to be a mixed blessing:
- On the one hand, it has been widely argued that, while competitive devaluations are self-defeating (since it is a logical impossibility for all countries to depreciate simultaneously), the implied monetary easing in each jurisdiction – and thereby in the world as a whole – is ultimately what is required to reflate the global economy. Via the pressure exerted by Euro appreciation, even a more independent and conservative central bank like the ECB will eventually be compelled to make a contribution in this direction.
- On the other hand, by undermining international economic cooperation, competitive devaluations threaten to weaken the global economic system and institutions. Protectionist pressures may re-emerge. Capital controls and financial repression may re-segment global financial markets. Having benefited over the past two decades from the favorable supply-side effects of globalization, such setbacks would threaten global growth.
Source: Citi and Goldman Sachs