Forex: Euro Weakness Seen vs. US Dollar Regardless of ECB Outcome

Talking Points:

• ECB to Keep Policy Unchanged, Focus on Mario Draghi Press Conference
• Euro Moves After ECB Outcome Unlikely to Alter Bearish Outlook vs. USD
• BOE Policy Announcement Likely a Non-Event, Focus on February Meeting

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An interest rate decision from the European Central Bank headlines the economic calendar in the hours ahead. While the current policy setting is expected to remain unchanged this time around, traders will be keen to dissect comments from ECB President Mario Draghi at the press conference following the announcement. The core CPI growth rate slowed to a record-low 0.7 percent year-on-year in December, raising red flags about a possible slide toward deflation absent action from the central bank.

Priced-in inflation expectations reflected in bond yields are effectively unchanged from where they stood when the ECB unexpectedly cut its benchmark rate to 25bps in November. Economists’ median 2014 end-of-year CPI forecasts have been revised significantly lower over the same period, down to 1.2 percent from 1.5 percent. This underscores the lack of meaningful easing to be had from reducing the policy rate from 50 to 25 basis points when the markets’ overnight Euro lending rate (EONIA) averaged just 8bps over the preceding 12 months.

December’s Eurozone PMI figures underscore the quandary facing the ECB: while overall growth seems to be recovering, pricing trends remain dismal. Furthermore, the recovery remains worryingly uneven across the various Eurozone member states, with Germany leading while France is lagging dramatically behind. That means the argument for looser policy remains formidable but the stimulus delivery mechanism needs to follow a non-conventional path that accounts for regional differentiation and pushes liquidity directly into the real economy.

With this in mind, investors will be most interested in any clues about how the ECB plans to overcome this formidable challenge. A number of options including a conditionality-amended LTRO program or a direct lending effort akin to the BOE’s FLS scheme are possible avenues. A relatively dovish rhetorical lean that foreshadows further accommodation is likely to weigh on the Euro, while more balanced tone may offer the single currency a near-term boost. Gains are likely to be short-lived however considering even a static ECB stance would imply a growing EUR-negative policy divergence with an actively “tapering” Federal Reserve. As such, we remain short EURUSD.

Meanwhile, this month’s policy announcement form the Bank of England is likely to be another non-event. The central bank is expected to maintain the status quo intact, which typically means it will not release a statement to explain itself. On balance, the key variable to watch is the unemployment rate threshold built into the BOE’s forward-guidance framework. Unexpectedly strong UK economic performance over recent months may compel the rate-setting MPC committee to lower its target level from 7 to 6.5 percent, thereby supporting recovery by cementing the perception that rates will remain low for some time yet. Such a move usually coincides with the publication of an updated Quarterly Inflation Report however, which puts the spotlight on February.

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--- Written by Ilya Spivak, Currency Strategist for DailyFX.com

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