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Euro Avoids Stimulus-Led Collapse but a Strong Rally Unlikely

Euro Avoids Stimulus-Led Collapse but a Strong Rally Unlikely

John Kicklighter, Chief Strategist
Euro_Avoids_Stimulus-Led_Collapse_but_a_Strong_Rally_Unlikely_body_eur.png, Euro Avoids Stimulus-Led Collapse but a Strong Rally Unlikely

Euro Avoids Stimulus-Led Collapse but a Strong Rally Unlikely

Fundamental Forecast for Euro: Neutral

- The ECB has signaled a significant monetary policy change of a return to stimulus

- Yet, short-term Euro-based rates continue to rebound, taking the Euro into a dangerous fundamental confrontation

- If you think an ECB stimulus return will eventually weigh the euro, consider a short Euro Currency Basket

It was a sense of relief that rallied the euro this past week. Fear that the ECB was building on an aggressive easing policy had bulls on edge and worked in a discount for the currency. After it became clear at this most recent meeting that November’s surprise rate cut would not be immediately followed by a new stimulus program, the shared currency responded with a ‘relief rally’. Yet, such moves in their very nature are limited in scope. A continuation move by the euro depends on tangible fundamental appeal that will draw capital into the region. Furthermore, a bull – or bear – run will be increasingly difficult to maintain as we have only two full trading weeks left in the year.

If we were to benchmark our outlook for the coming week to the Euro’s performance last week, our expectations would be artificially inflated. After the Eurozone’s October inflation report plunged to a four-year low (Oct 31), the currency pitched into a sharp decline as speculators interpreted the data as the missing ingredient – along with tepid growth, fading loan growth and near-term exit from bailout programs – to encourage the central bank to reverse its shrinking balance sheet. Those expectations / fears were proven correct on November 7 when the group unexpectedly lowered the benchmark lending rate 25 bps to 0.25 percent.

A rate cut – especially when already near the zero bound – offers limited economic benefit and detrimental currency impact. Follow through on the selloff was limited as the focused shifted to the more effective tool for currency manipulation: stimulus plans. Expectations of an immediate adoption of a new LSAP (large-scale asset purchase program) or the like so soon after the rate move were limited. As such, the euro’s slump against the dollar, pound and franc cooled quickly. It was that modest premium that remained on the off-chance of an aggressive ECB move that was promptly covered when President Draghi kept the status quo.

We should not take last week’s developments to mean that the European Central Bank will continue to allow their balance sheet shrink with the repayment of their two large bank-based stimulus programs (LTRO1 and LTRO2) and thereby boost the region’s yield and currency. Given the slow recovery of economic activity, slide in lending, appearance of disinflation and rising exchange rate for the Euro-area; a stimulus shift would be a likely preemptive and corrective move. Yet, the important consideration for our immediate trading purposes is that it won’t occur before the year-end liquidity drain.

By the week of the 23rd, the bulk of business, fiscal and investment decisions will be put on pause until the new year. That removes an impetus for significant trades but it also removes the risk of volatility – which is typically detrimental to the prevailing trend. In response, we have seen one-month EURUSD implied (expected) volatility collapse to its lowest level since August 2007.

Low perceived risk will work as a curb to most bearish scenarios related to the scheduled event risk for the week ahead. At the top of list this week is the Eurozone Finance Ministers’ meetings. Monday’s gathering in particular is expected to return to the topic of Greece and its bailout conditions following recent debate over their progress.

Other fundamental fodder to keep track of can be separated into monetary policy cues and traditional economic data. For the latter, Eurozone investor sentiment, a Bloomberg-measured Economic survey, and German trade figures. Otherwise, the ECB monthly report and two scheduled speeches by ECB President Draghi will update rate watchers on their stimulus expectations. – JK

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