“EUR/USD moved further away from fair-value of 1.1150 based on 10y real rates over the past 24 hours” – Soc Gen
Barclays warn dovish language from ECB could see a more marked retracement lower in Euro
The Euro is strong, but can it get stronger? Key to answering this question will be the direction of Eurozone monetary policy set out by the European Central Bank at their July interest rate meeting.
Nerves have emerged ahead of the meeting with some traders exiting the market incase the ECB should spring a nasty surprise in an attempt to halt the currency’s advance.
After all, a strengthening Euro work’s against the Bank’s agenda of keeping monetary conditions in the Eurozone ultra-stimulative.
The world’s largest foreign exchange dealer, Citi, have dug into their data and found that the Euro’s strong run higher could be about to be tested.
Analysts note that hedge funds are becoming wary of the Euro with this particular sector of the market becoming net sellers of the currency.
“Much of it likely taking profit which could be an early sign of turning point. In addition, going into the ECB press conference on Thursday, these clients will likely have long EUR exposure so any dovish signals could lead to a sell-off,” says Scott Dingman at Citi.
Meanwhile, Kenneth Broux at Societe Generale notes the Euro is starting to look a little expensive.
“EUR/USD moved further away from fair-value of 1.1150 based on 10y real rates over the past 24 hours, causing speculation to intensify that the ECB will have no option but to try to slow the pace appreciation of the single currency tomorrow,” says Broux.
The observations come amidst reports that ECB staff are already studying various option to wind down its stimulus.
No decision is therefore likely to be announced at the Thursday meeting and confirms that earliest moves on the matter are likely to come at the September meeting.
The same report says Governing Council members are in agreement that they need to move carefully on announcing the end of the ECB’s stimulus programme.
The chief concern for the ECB is that investors might jump on any signal that bond purchases are about to be tapered, pushing up market interest rates and the Euro which would in turn undermine the Eurozone recovery.
“The appreciation of the single currency will blunt inflation expectations, the central bank’s policy compass,” says Broux.
“The ECB no doubt must be irked at the melt-up above 1.15, unless it is planning to signal the end of QE tomorrow, which frankly no one is expecting and would come as a bombshell,” says Broux.
But then again, what can the ECB really do to squash the Euro advance?
The toolbox is looking a little empty to us – Draghi can’t go nuclear on rates and the Euro with his language just months ahead of announcing what would be in effect a position that is completely contrary.
“The bank’s options are limited, however as some of the recent gains have been led by the fall in the USD,” notes Broux.
So at worst a slight profit-taking pullback in the Euro is possible.
“We still believe that the future for the euro is higher, however, it may not be a straight line to 1.20 for EUR/USD. Thus, a dovish Draghi, who may choose to focus on weak inflation pressure and ignore any prospect of tapering the APP programme, could see EUR/USD fall back to the 1.1330 lows from earlier this month,” says Kathleen Brooks at City Index.
There might also be technical resistance to the Euro’s advance.
EUR/USD has twice in the past two years failed to gain a foothold above 1.15/1.16.
The first of the two instances followed the CNY devaluation in August 2015, which sparked a sell-off in risk assets.
Then the rally in May 2016 coincided with the dovish Fed meeting in April.
“Could it be third time lucky, or does ECB President Draghi force participants back in line?” asks Broux.
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Hamish Pepper at Barclays warns against complacency, pointing out that risks are assymetrically positioned – i.e the move in one direction will be significantly larger than the move in the opposite direction.
“The ECB is widely expected to leave its policy settings unchanged on Thursday, but the statement language represents asymmetric risk to the EUR, in our view.
“A confirmation of the hawkish language introduced by President Draghi during the Forum in Portugal should result in only a limited sell-off in short-end interest rates, with very modest upside risks for EURUSD.
“The rates market, for example, already implies almost 10bp of deposit rate hikes over the next year versus less than 3bp prior to President Draghi’s speech, and throughout this time EURUSD has appreciated about 2.5%.
“Dovish language, on the other hand, could see a more marked retracement as investors reassess expectations of both deposit rate hikes and the pace of asset purchases.”
What does this Mean for Euro v Pound?
Turning specifically to Sterling-Euro, analyst Robin Wilkin at Lloyds Bank says he feels the Euro’s ability to rally further against Pound Sterling at this juncture is limited, “particularly given divergence in momentum in EURUSD could stall EUR strength”.
Further, Wilkin notes the high concentration of option strikes on EUR/GBP between 0.88 and 0.90 may keep prices close to these parameters.
EUR/GBP at 0.88 equals a Pound to Euro exchange rate of 1.1364 and 1.11.
Unwavering Positive Sentiment on Global Markets
Looking at the broader markets ahead of the ECB event, the US Nasdaq set another record-higher over the course of the past 24 hours amidst continued investor bullishness.
But, European markets failed to capitalise on last week’s rally, hamstrung by Euro strength so it would certainly be a blessing for stock market investors if Draghi managed to prompt some weakness in the exchange rate.
In London the FTSE 100 continues its fight to hold 7400, although this morning it does not have the aid of mining sector strength that was so notable yesterday.
BHP Billiton’s record production in some operations is not the kind of news to excite investors, who are keeping a wary eye on commodity prices and production levels.
Having rallied by almost a fifth since the June lows, BHP and other miners look vulnerable to some selling, particularly if the US dollar finds its footing.
Earnings season so far has avoided any nasty surprises, and Morgan Stanley becomes the latest big financial institution to step up.
Goldman Sachs’ slump in trading revenues certainly worried markets, especially since there seems no let-up in the low volatility that has prevailed all year. Meanwhile there seems no stopping the tech rally, fired up as it was by Netflix.
Valuation worries could be easily laid to rest if the sector keeps up the positive newsflow. Ahead of the open, we expect the Dow to start at 21,557, 17 points lower from Tuesday’s close.