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Euro Collapse Versus Dollar as Much an ECB Factor as Risk Trends

Euro Collapse Versus Dollar as Much an ECB Factor as Risk Trends

John Kicklighter, Chief Strategist
Euro_Collapse_Versus_Dollar_as_Much_an_ECB_Factor_as_Risk_Trends_body_Picture_1.png, Euro Collapse Versus Dollar as Much an ECB Factor as Risk Trends

Euro Collapse Versus Dollar as Much an ECB Factor as Risk Trends

Fundamental Forecast for Euro: Neutral

  • The ECB rate decision will be a critical event for euro price action both in the lead up and reaction
  • A change from a tightening stimulus effort to an expansive one can sink the euro across the market
  • Find signals, speculative positioning and webinars on the Euro in DailyFX-Plus this week

The Euro was the worst performer of the majors – and the drop it suffered was nothing short of spectacular. However, that incredible momentum may not be as established as many bulls fear and bears hope. The same fundamental drive that set the currency alight this past week could very well snuff the tumble out through the opening half of the week ahead. While FX traders will be attuned to any disturbance in the web of general risk trends, anxious chop or heavy swings for the euro this week will likely be more dependent on native event risk – namely the ECB rate decision.

The European Central Bank policy meeting is scheduled this Thursday for 12:45 GMT. For the last few policy gatherings, the market’s attitude towards the event was one of aloofness. As it should be. While there have been a few head turning remarks in the statements and comments from ECB President Draghi’s press conferences, the ECB hasn’t actually changed policy since the May 2 rate cut (25 basis points to the current 0.50 percent). However, over the weeks and months we have seen a notable persistence in Euro-area economic malaise, a slowing global picture and a troubling rise in regional interest rates.

In reality, the fundamental backdrop for the euro has been ‘uneven’ for some time. However, the global financial markets have shown an incredible tolerance for ongoing recessions, relaxed budget efforts, austerity renegotiation and even ‘bail-ins’ for some time. It has simply become a familiar part of the currency’s and region’s backdrop which has in turn morphed into a sort of apathy. Yet, that tranquility was disturbed this past week with the release of two particularly troubled indicators: Eurozone unemployment and CPI.

A record high 12.2 percent jobless rate is certainly disturbing when set against the permanent optimism and reassurances of European leadership. Yet, alone, that data would not likely have shaken the euro. What truly unsettled investors was the unexpected, sharp drop in the year-over-year consumer inflation report for October – to 0.7 percent. A four-year low, this indicator not only allows the central bank room to further ease policy in order to support austerity-razed economies, it may even necessitate to some extent should officials fear the feedback from disinflation.

In terms of easing, the immediate expectation for many is a follow up rate cut. However, at 0.50 percent and with plenty of examples of the failed response to marginal reductions in near-zero rates, it would be an unsuccessful and unlikely option. Instead, the ECB may contemplate another lending program – much like the LTRO (long-term refinancing operation) programs from 2011 and 2012. In fact, with the early repayment of these three-year, low rate loans by European banks; we have seen the ECB’s balance sheet shrink since last June and short-term interest rates rise since the turn of the year. Higher rates for still-struggling economies expected to soon return to the market and a smaller buffer for the financial system is a dangerous mix.

With the sharp drop from the euro this past week, it would seem that the market is concerned that shift in policy is a considerable probability. Yet, there is nuance to this event. If the central bank defers a difficult decision this time while leaving the market with a warning that a new stimulus move could be introduced in the near future, the market may still be shaken. It depends on how aggressively the market adjusts for such a scenario. If we extended the correction from this past week up until the rate decision, a hold in any form would likely see a speculative bounce on covering. Alternatively, if the euro stalls through the first half of the week – a considerable probability as speculators are sidelined by the impending event risk – the euro may still be deemed richly priced and drop.

While the ECB decision will be the clear draw of the week for euro traders, there is plenty of other local event risk to take in even if it is incorporated without immediate volatility. Worth watching are the EU economic forecasts, Spain unemployment change, Troika return to Athens (all Tuesday), service sector activity data (Wednesday) and Bank of Italy lending figures (Friday). JK

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.