Further Euro Strength Suspect as Data Deteriorates; ECB Very Likely to Act

Fundamental Forecast for EUR/USD: Neutral

- EUR/USD’s technical bias has thus far led to higher exchange rates…

- …but there’s little reason to trust the EUR/USD this far from the ECB’s NEER.

- Compares the Euro’s performance halfway through the quarter to our Q1’16 forecast.

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The Euro is doing nothing more than meandering around versus the rest of its major counterparts, seemingly oblivious to developments at home as (admittedly) more interesting developments take place abroad: the Federal Reserve’s cheeky attempt at normalizing policy; Chinese/emerging market growth slowing down rapidly; and geopolitical tensions between military superpowers ratcheting higher across all corners of the globe. All of it makes for a rather distracting trading environment, and less ‘flashy’ developments can easily be overlooked.

A look under the surface shows that the Euro-Zone is starting to face more difficulties of its own as the calendar approaches the halfway mark of Q1’16. Much like its American counterpart across the pond, the Euro-Zone economy is off to a disappointing start to 2016. Per the Citi Economic Surprise Index, US data momentum is off to its worst start over the past 10 years, while Euro-Zone data momentum isn’t that much less disappointing:

Chart 1: Euro-Zone and US Citi Economic Surprise Indexes – 10 year Seasonality

Further Euro Strength Suspect as Data Deteriorates; ECB Very Likely to Act

The narrative early in the year, one that continued over from December (and was very much the case at the European Central Bank’s last policy meeting of the year), was that Euro-Zone data ex-inflation was doing well enough to keep the ECB on the sideline. That’s just not the case anymore after several weeks of softer economic data.

From the Euro's perspective, it’s important to consider why the ECB cut its deposit rate on December 3 – and did not make changes above what the markets had already priced in for the QE program. Financial conditions were not considered a headwind with the EUR/USD trading nearly -5% below the ECB’s EUR/USD NEER (nominal effective exchange rate, the technical assumption underpinning the ECB’s growth and inflation forecasts) at the time of the December meeting. Between data ex-inflation being firmer and the exchange rate so low relative to its technical assumption, the ECB deemed it wasn’t time to use its “bazooka,” and the Euro screamed higher.

Chart 2: EUR/USD Spot versus ECB’s EUR/USD NEER (August 10, 2015 to February 12, 2016)

Further Euro Strength Suspect as Data Deteriorates; ECB Very Likely to Act

A stronger EUR/USD makes the price transmission mechanism in the Euro-Zone slower, which is becoming problematic for the ECB now that the spot rate is rising above the ECB’s NEER. With the ECB’s NEER technical assumption due at $1.0900 for 2016, the closing price last week of $1.1152 was +2.31% above the ECB’s technical assumption for 2016. At its max closing level last week, this differential was +3.87%. Ahead of the ECB pre-announcing its deposit rate cut at its October meeting, EUR/USD had closed as high as +3.37% above the ECB’s technical assumption for 2015 (at the time: $1.1100).

While part or even most of the data slowdown may be attributed to exogenous forces, it doesn’t mean that the ECB won’t take measure to shore up their easing measures. These observations lead us to believe that we’re starting to get into the territory where ECB policy officials may start to become a bit more vocal about the exchange rate on approach to the March meeting. As we stated in our Q1’16 Euro quarterly forecast, we believe that, reflexively, a stronger EUR/USD has increased the probability of the ECB acting again in March. Markets think so too: forward rates have already priced in another 10-bps rate cut by the ECB at their next meeting:

Chart 3: EONIA versus EONIA 1-month FRA

Further Euro Strength Suspect as Data Deteriorates; ECB Very Likely to Act

At this point in time, a stronger Euro is the Euro’s biggest enemy. The longer that the US Dollar stays under pressure – which is looking more probable from a technical perspective – the greater the issue the ECB will have with the EUR/USD exchange rate. All things considered, the ECB more or less has to act again in March; but given that rates markets are already pricing in a 10-bps rate cut, it may not but enough to keep EUR/USD pinned lower for longer (just like in December 2015). –CV

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