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Euro_Rally_Begins_on_Better_Data_Will_EONIA_Rates_Force_ECB_Action_body_Picture_1.png, Euro Rally Begins on Better Data – Will EONIA Rates Force ECB Action?

Fundamental Forecast for Euro: Bullish

- The Euro entered the week directionless, at the behest of growth data losing momentum…

- …but better than expected January PMI readings across the region sparked a midweek breakout.

- On a technical basis, the EURUSD is primed to rally further after holding key support.

The Euro proved resilient the past week, gaining one percent or more against four of the other seven major currencies, while holding its own against the top two performers, the Japanese Yen and the Swiss Franc. The EURJPY (-0.94%) and EURCHF (-0.72%) tumbles can largely be attributed to a global shift to safer assets, with equity markets sliding and high-rated sovereign debt rallying (German Bunds, US Treasuries).

Yet as concerns cropped up elsewhere, in emerging markets and the Asian-Australasian theatre (EURAUD +2.12%, EURNZD +1.51%) as well as North America (EURCAD +2.12%, EURUSD +1.00%), the Euro’s fundamental backdrop strengthened. The January PMI figures, coming off of a mixed batch in December – which prompted the Euro’s early-January tumble – came in well above expectations, further supporting our core theme for 2014: faster rates of growth return to the European continent.

Markets may not necessarily treat any data this week with more importance than the January CPI figures due on Thursday and Friday. The German Consumer Price Index is expected to see some turbulence: the monthly figure is due lower by -0.4% after a +0.4% gain in December; but the yearly figure is forecast to increase to +1.5% from +1.4%. On Friday, the Euro-Zone CPI Estimate (JAN) will rise to +0.9% from +0.8% (y/y), according to consensus forecasts.

In all, these data are not reassuring enough so as to deter “deflation” conversation from popping up, which has tended to be bearish for the single currency given the European Central Bank’s response – to cut its main interest rate to a record low of 0.25%. Even so, the ECB may not react immediately if the inflation data remain tepid.

At the World Economic Forum in Davos, Switzerland, ECB President Mario Draghi explicitly said that "I don't see deflation in the euro area…medium-term inflation expectation remain firmly anchored at +2%." Translation: low inflation isn’t reflecting declining growth conditions (diminishing demand, putting downside pressure on prices), but something else – weak credit growth.

Certainly, if there is ever a reason for the ECB to act, it would be to ensure that liquidity remains plentiful by keeping short-term rates anchored low for the foreseeable future. Funding stresses could be starting to appear: overnight EONIA rates (interbank lending rates) have been trending higher the past few weeks, with readings as high as 0.446% on December 31, 2013 and 0.359% on Monday, January 20, 2014. These are the highest readings since the President Draghi was forced to stake out his “whatever it takes” claim to save the Euro in July 2012.

In light of the fact that Italian and Spanish bond yields remain exceptionally low (by crisis norms), the recent upswing in EONIA rates may not be worth worrying about (in theory they could stoke a more dovish ECB, thereby hurting the Euro). Excess liquidity in the Euro-Zone stands at €161B but only after dipping as low as €125B on January 21. This means that the rising EONIA rate may be tied to LTRO repayments (EONIA rates spiked on January 20).

A BoE-styled Funding for Lending Scheme (FLS) could address credit concerns without putting the Euro at risk of a massive ECB balance sheet expansion that another LTRO or a Fed-styled QE would bring. With the EURUSD technically poised for a bullish move, we take these considerations into account and surmise a bullish bias for the Euro this week. –CV

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