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Did Draghi Finally Find a Recipe For Strength?

Did Draghi Finally Find a Recipe For Strength?

Fundamental Forecast for Euro: Bullish

The most recent European Central Bank meeting was a pretty big deal. And not just because of the larger-than-expected increase to the bank’s QE program, nor was it the further reduction of the deposit rate to -.4%. It wasn’t even the broad-based cut to zero of the benchmark and lending rates. The most surprising aspect of the most recent ECB meeting was the enhancement to the bank’s TLTRO program. This is something that could potentially provide a lasting impact for European banks as well as the Euro currency. Both of which could’ve potentially been under immense pressure with a further decrease to the bank’s already negative deposit rate.

The enhancement to the ECB’s TLTRO program will essentially allow the European Central Bank to pay European banks to lend money to borrowers. The under-side of the ECB’s negative rates is the additional pressure that gets added to an already-weakened banking sector. If banks are getting charged for keeping deposits with the Central Bank, they’ll likely just move their money elsewhere. This leads to a weaker currency as banks in Europe move capital into American or Japanese branches to put that capital on deposit with foreign Central Banks. This can also nullify the goals of QE as banks basically just use that freshly injected capital to deposit the funds elsewhere to earn a meager rate of interest (at least they aren’t being charged). This is like a carry trade at an abysmal rate of interest; but because of the low risk of keeping funds on deposit at Central Banks, this remained as a valid strategy.

At the most recent ECB meeting, Mr. Mario Draghi announced that the updated TLTRO strategy that will allow banks to receive more favorable interest rates based on the bank’s eligible net lending exceeding their benchmark. As outlined last week by Christopher Vecchio, banks can actually get paid by the ECB to borrow money - from the ECB. This basically allows the ECB to direct banks to lend capital to borrowers rather than transferring capital with the goal of avoiding negative rates. As Chris had outlined, this allows the ECB to target credit rather than FX.

So, there are reasons for support to be seen in European Banks and the Euro currency on the back of the ECB’s moves, both of which continued this week as European bank Credit Default Swaps (bets on bankruptcies in European Banks) have continued to price lower, while the Euro continued to strengthen; gaining another iteration of strength after the Federal Reserve took a dovish stance towards 2016 rate hikes.

Next week is devoid of high-importance news events out of Europe, but there are numerous medium and low-importance announcements on the docket. The highlights are German data on Tuesday, both the IFO and the German Zew Survey, while Wednesday brings consumer confidence numbers and Thursday brings PMI’s for the Euro-Zone, France and Germany. Each of these could be market moving, but given that much of this data was compiled before the announcement of Mr. Draghi, expect down-side prints to be somewhat muted while top-side data gets accentuated by markets.

For next week, we adopt a bullish stance on the Euro as positioning remains stretched to the down-side while prices have continued to rise, and this most recent move from the ECB will likely continue to bring strength into the European banking sector which can certainly drive additional capital flows into Europe, the Euro and European Banks. As a supplemental factor, it would appear that Central Banks are trying to avoid ‘beggar thy neighbor,’ weakness-based regimes.

For a technical setup to watch if looking to get long EUR/USD, please feel free to check out the article, EUR/USD and USD/JPY Working With Significant Fibonacci Levels.

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