The EUR/USD rallies, European equities plummet. Expectations were dashed around Draghi “acting” today on QE and interest rates – he lowered the deposit rate 10bps to -0.30%, kept the main interest rate unchanged at +0.05%, and extended, but importantly did not increase the €60 Billion/month QE program (now until March 2017).
What does today’s market action mean? Investors were holding a massive short position in the EUR/USD going into today’s announcement. [See first CFTC chart below]. The lack of “action” caused a short covering squeeze in the EUR/USD and equities fell as the lack of “drugs” deflated the hope trade that QE raises the tide of all boats.
Our mantra remains the same. We maintain our macro theme of #EuropeSlowing, with our proprietary GIP (growth, inflation, policy) model signaling the Eurozone in #Quad3 (growth slowing as inflation accelerates) in the coming quarters [Second chart below]. Today the Bank’s staff revised its December GDP and CPI projections versus September – not surprising, they were revised lower!
What’s our policy outlook? There’s an increased likelihood that the ECB has to act by expanding the size of its QE program (to €75-95B/month), likely within the first quarter of 2016, as again the Bank underperforms its growth and inflation expectations while its policy measures impart limited results on on the “real” economy. Today Draghi (with limited detail) expanded the scope of eligible regional and local debt for purchase – we expect even more leniency on what it may purchase in the coming quarters.
Old Song and Dance. Today’s presser showed once again Draghi’s mentality to Extend&Pretend economic gravity. Draghi did not rule out that the ECB was at the lower bound of deposit range, but more importantly, when asked why the ECB chooses to cut the deposit rate, he replied: "We simply observed that cuts improve the transmission of monetary policy". We have yet to see proof of that.
Draghi again went back to his truisms, like “The recovery is becoming broader, and driven by consumption rather than exports. Savings rate is also flat, another positive sign.” Draghi confuses economic conditions and what may prove to be very accommodative financial conditions: we’ll certainly take the other side of his view that economic conditions are all well and good, and showing signs of improvement.
EUR/USD Levels: The EUR/USD broke through our TRADE (3 weeks are less) resistance level today, yet remains comfortably below our TREND (3 weeks or more) resistance levels. One day does not a TRADE or TREND make. We maintain a bearish bias on the EUR/USD, yet much depends on U.S. data (jobs report out tomorrow) and the policy of Janet Yellen’s Fed at its December 15-16 meeting.
December ECB Staff Projections:
- Eurozone GDP Projections foresee annual real GDP increasing by 1.5% in 2015 (vs 1.4% in Sept), 1.7% in 2016 (1.7%) and 1.9% in 2017 (1.8%)
- Eurozone CPI Projections foresee annual inflation at 0.1% in 2015 (0.1% in Sept), 1.0% in 2016 (1.1%) and 1.6% in 2017 (1.7%)
Governing Council Decisions/Updates:
- Maintains interest rate +0.05% and lending facility +0.30%
- Cut deposit facility by 10 basis points to -0.30%
- Extend asset purchase program to March 2017 (vs September 2016) or beyond if necessary – until sustain adjustment in path of inflation to achieve 2.0% target over medium term
- Maintains €60 Billion/month program
- Decides to reinvest principal payments of securities purchased under the asset purchase program as they mature for as long as necessary – the goal is to increase liquidity
- Decides to include euro-denominated marketable debt instruments issued by regional and local governments in the euro area as assets eligible for regular purchases
- Decides to continue conducting the main refinancing operations and 3-month longer-term refinancing operations as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the last reserve maintenance period of 2017
-Matthew Hedrick, Associate
Where is the U.S. Dollar Headed From Here?
The EUR/USD cross has rallied nearly 3% today with the preponderance of the move coming on the heels of the ECB’s wet Kleenex of a policy announcement. Simply put, the market is challenging Draghi’s ability to meet lofty expectations for Eurozone monetary easing on a go-forward basis.
Obviously whenever you see a major currency cross gap up 4 big figures in a matter of hours, it’s easy to point to short covering as the primary factor. But with speculative net length in EUR futures and options contracts already having consolidated a fair amount from the perspective of our Z-Score analysis, one could make the case that today’s move is being perpetuated by a fair amount of incremental open interest on the long side. It’s worth noting that the current speculative net length of 45,977 contracts on the DXY is in the 89th percentile of all weekly readings dating back 10 years. The key takeaway here is that there’s a lot of hay to bale to the extent investors need to begin exiting crowded long-USD trades.
What could cause that to happen? The obvious answer is the Federal Reserve openly acknowledging the ongoing and prospective degradation in domestic economic growth that is embedded in our #LateCycle theme.
Said degradation is now painfully obvious for all to see and continues to be corroborated by high-frequency data, at the margins – most recently highlighted today by the sequentially soft November ISM Non-Manufacturing PMI reading. Specifically:
- Various measures of household consumption growth (e.g. Real PCE, Retail Sales) are decelerating on both a sequential and trending basis;
- Industrial production growth is decelerating on both a sequential and trending basis;
- Export growth is decelerating on a trending basis and still contracting from a YoY perspective;
- PMI readings are decelerating on both a sequential and trending basis;
- Consumer confidence is decelerating on both a sequential and trending basis; and
- Producer price inflation (a proxy for corporate revenue growth) is decelerating on both a sequential and trending basis.
Unfortunately for market participants, the FOMC remains completely out to lunch with respect to their [serially overoptimistic] economic projections and, commensurately, their “dot plot” for the Fed Funds Target Rate – both of which are completely at odds with trends across a number of relevant indicators. This disconnect makes formulating a TREND duration view on the direction of the DXY rather difficult, to say the least. Specifically, the data would imply lower-highs, but a high probability of [unwarranted] intervention by the Fed in the form of a rate hike(s) should not be ignored.
On one hand, both history and our dour cyclical outlook for the U.S. economy would support adopting a bearish bias on the U.S. dollar from here.
On the other hand, our dour cyclical outlook for the Eurozone economy and relative distance from achieving its stated policy objectives would support adopting a bearish bias on the EUR from here. The 10Y breakeven rate in the Eurozone is a mere 1.15%, while the Bloomberg consensus estimate for Eurozone CPI in 2016 is only 1.1%; both are well shy of the ECB’s 2% target for “price stability”. This compares to 1.84% and 1.8% for the 5Y-5Y forward breakeven rate in the U.S. and the Bloomberg consensus 2016 U.S. CPI estimate, respectively. Our thought process here is that the further a given central bank is from its stated policy objectives, the higher the propensity is for it to ease at every interval – which is the ECB at the current juncture.
Given the obvious counterbalancing forces, you could make the case that the EUR/USD cross should trade in an increasingly narrow range from here. That said, however, the aforementioned positing and sentiment data would seem to suggest that the path of least resistance is actually higher for the EUR/USD – at least until Draghi corrects today’s policy mistake with a substantially more meaningful expansion of Europe’s QE program.
A lower dollar could prove very bullish in the short term for reflation assets (energy, raw materials, EM stocks, EM FX, EM LC debt, etc.), but that is not a call we are willing to make in the absence of more data. How the Fed interprets tomorrow’s Jobs Report will be very telling on that front indeed…
-Darius Dale, Director