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Euro Lacking Direction as Data Momentum Improves, Brexit Concerns Ebb

Euro Lacking Direction as Data Momentum Improves, Brexit Concerns Ebb

2016-05-09 00:36:00
Christopher Vecchio, CFA, Senior Strategist
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Euro Lacking Direction as Data Momentum Improves, Brexit Concerns Ebb

Fundamental Forecast for EUR/USD: Neutral

- Twenty year seasonality trends suggest EUR/USD could slip in May.

- The retail crowd remains net-short EUR/USD – see live SSI updates.

- Read the EUR/USD quarterly forecast, “EUR/USD Stuck in No Man’s Land’s Headed into Q2’16 – Don’t Discount ‘Brexit’”

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After another rough week for global equities, higher yielding currencies, and risk-correlated assets, it’s a good time to step back and reassess how we’ve arrived here. One common thread runs through the past few weeks: central banks aren’t looking as supportive as they were at the dawn of Q2’16. Indeed, in the second half of April, the Bank of Japan failed to step into markets to stop a rapidly rising Japanese Yen, while various Federal Reserve officials have started to step up their hawkish tone in preparation for a possible June rate hike. The liquidity spigot appears to be shuddered.

For the Euro, these developments – that central banks aren’t as quick to act during years past – started to materialize back in March. At the March ECB meeting, President Mario Draghi made clear that the ECB would no longer be targeting the FX channel via its unconventional easing policies. As we wrote at the time, this should have (and has in actuality) given the Euro room to breathe. This was an important psychological shift: if the ECB felt that it could no longer effectively keep the Euro down, why would the market have faith that it would itself?

Alas, the ECB may be vindicated thus far. The Citi Economic Surprise Index for the Euro-Zone, a gauge of economic data momentum (actuals versus expectations) closed last week at -11.0, up from -22.0 on April 1. Similarly, the 5-year, 5-year inflation swap rate has increased from 1.411% to 1.464% over this same timeframe. As a result, overnight index swaps and EONIA forward rates have pushed back the implied timeframe for more easing from the ECB from October to December. Implicitly, expectations for future rates have become less dovish, which may be supporting the Euro.

As long as economic data continues to improve and inflation expectations steadily point higher – evidence that the ECB’s current set of policies are having their intended impact – then traders shouldn’t be counting on the ECB to step back into the market any time soon. The forthcoming calendar is loaded with important data from Germany and the Euro-Zone, but market participants will be eying Friday’s dual Q1’16 GDP releases as the capstone to a busy week. As always, no one individual set of data is too important: it’s important to view the updates in aggregate.

Beyond the immediate time horizon, it’s important to keep perspective regarding the UK’s June 23 EU referendum. While opinion polls are split, UK betting markets are heavily favoring the UK to stay in the EU. This would be a small, but important, victory for the Euro. While a ‘yes’ vote on June 23 wouldn’t trigger an automatic dismissal from the EU (hardly; a two-year negotiating window would open up with any number of outcomes viable), it would open up the Pandora’s Box of speculation: markets would begin trying to price what varying forms of an EU breakup would look like. But as things stand now, the Brexit vote should come and go without significantly hurting the Euro – and the tail risk being pulled off the table might actually help depress volatility in the short-term, allowing the Euro to rally thereafter. –CV

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If you haven't yet, read the Q2'16 Euro Forecast, "EUR/USD Stuck in No-Man’s Land Headed into Q2’16; Don’t Discount ’Brexit’," as well as the rest of all of DailyFX's Q2'16 quarterly forecasts.

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