ECB policy: Less dovish does not mean hawkish

Last week, Mario Draghi announced that the ECB would drop the commitment to increase its bond-buying programme should “the outlook become less favourable” – a pledge dating from December 2016 when the ECB first began to cut its bond-buying programme.   This pledge was widely considered to be the ECB’s signal to the markets that it had a dovish bias and so its removal last week was important, as in some ways it represents the first step towards European monetary policy normalization.


As such, you might have expected the euro to strengthen on this announcement – maybe even break through the stubborn 1.25 resistance level which has held back EURUSD in recent weeks.  And while the EUR did strengthen briefly, it quickly dropped over a cent, with EURUSD settling around the 1.23 level. 


There are a couple of explanations for the euro’s counterintuitive price action.  First of all, this is a classic “sell the news” event.  The euro has been rallying for over a year now, predicated on the belief that the ECB would begin to normalize monetary policy – now that Draghi has confirmed this, many investors will feel that it is time to get out of the trade.  This can be seen in the speculative positioning numbers, which show that hedge funds and other investors have cut their wagers on further euro strength by over 10% (albeit from record levels).


Secondly, Draghi also lowered his inflation expectations slightly – moving the 2019 inflation forecast to 1.4% (from 1.5% previously).  This might seem like a pretty minor revision, which nominally-speaking it is, but it is actually highly significant.  European inflation is well below the ECB’s 2% target, it is moving down rather than up (February’s inflation number was 1.2%, down from 1.3% in January and 1.4% in December), and the ECB has now confirmed that it does not expect any meaningful change for over a year.  This is in stark contrast to both the US and the UK, where inflation is now comfortably above 2% (too comfortably above in the case of the UK).



CHART: Euro Positioning

Source: Bloomberg



In other words, while the ECB has ditched its ‘dovish bias’, it is a long way away from following the Fed and embarking on interest rate hikes in the months ahead.  In fact, the probability of an ECB rate hike in 2018 declined by almost 25% following Draghi’s statement last week (and now sits just above 20%).  Throw a potential trade war with the US into the mix (and whatever the rights and wrongs of Donald Trump’s trade philosophy are, he is right that Europe relies on trade a lot more than America does), and we remain comfortable with our bearish call for EURUSD for 2018.  



Kevin Lester


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