ECB gives the greenlight for more euro strength, but market jitters scupper rally
The ECB meeting on Thursday was considered “hawkish” by the market, or at least hawkish in the context of a global pandemic. The ECB left policy unchanged, which was widely anticipated, however, they didn’t point towards any future increase in policy accommodation, there was no talk about deeper interest rate cuts or more asset purchases, and the ECB did not sound overly concerned about the strength of the euro. The result was an immediate jump in the euro across the board, EUR/USD rose above $1.19 at one point, however, as we end Thursday the rally has faded and the single currency has given back all of its ECB-related gains as risk appetite more generally has gone back into reverse.
Looking at the ECB meeting more closely, the ECB wisely did not pick a fight with the FX market and try to talk down the euro. Previous presidents of the ECB have tried this, think Trichet and Draghi, to little effect. Usually, when a central bank head attempts to talk down their currency it has the opposite effect and the currency rises. Lagarde knows that trying to go against the flow of the FX market is futile and often costly, so she didn’t try it. She mentioned that there had been a discussion during the ECB’s policy-setting meeting about the euro exchange rate, however, no concrete action was taken. This does not mean that the ECB does not care about euro strength, rather that Lagarde et al might look at other factors to try and bring down the strength of the euro, which has risen to its highest level in more than two years vs. the USD. Other ways to limit future euro strength include:
· An increase in its asset purchase scheme, which could happen in December.
· A deterioration in the Euro-area’s economic data, caused by a second spike of the coronavirus and more wide-spread lockdowns.
· Geopolitical events and a longer period of risk aversion across financial markets.
The first point is likely to happen, and the market is expecting more policy support from the ECB by the end of the year. On the second point, the ECB started its press conference by pointing out how robust the Euro area’s economic recovery has been, after a spate of decent economic data including confirmation that the euro area’s GDP declined 11.8% in Q2, significantly better than the economic decline in the US and the UK. Added to this there was a near 5% increase in German exports for July. However, the global economic recovery remains fragile and the recovery in the Eurozone has been patchy, for example Italian retail sales fell more than 2% in July. Thus, if the economic data starts to decline in the coming weeks then the euro is likely to fall.
The euro and global risk aversion
Luckily for Christine Lagarde, some of the work of weakening the euro was done for her by the continued sell-off in US stocks on Thursday. This helped to push up the price of safe havens including the US dollar, gold and US treasuries (yields fell). The trigger for the decline in US stocks was two-fold, firstly the pick-up in US jobless claims for last week, which could suggest broader economic stresses as we move into the Autumn, secondly, markets were spooked by news that the US Congress had failed to make progress on a new stimulus programme. The reluctance of the US to pass more stimulus measures, along with a “hawkish” ECB was enough to push global stock markets lower.
As we move to the end of the week three questions will be central to traders.
1. Will EUR/USD claw back recent losses and make another attempt at $1.20? The technical indicators are still supportive of euro strength, and there has been some support around $1.1815, and euro bulls will be hoping for a recovery from here. Otherwise, support lies at $1.18, a break below this level would be a psychological blow for euro bulls.
2. What next for US stocks? This is a critical question and one we will ponder over the weekend. While we think that the recent decline in stocks is to be expected after the extraordinary rally for tech stocks and the elevated p/e levels, we need to balance this with the fact that the Fed is pumping money into the global economy and interest rates are expected to remain low for the foreseeable future. Thus, while we may see a further sell off in the next week or so, overall, we believe that the stock market will recover. However, expensive US tech stocks may not lead the recovery, instead we could see cheaper European stocks, and even UK stocks, leading a recovery in the global markets.
3. Will the pound remain under pressure? Pound bulls can blame the government for the sharp decline in sterling this week. The breakdown in EU/UK trade deal talks is the key driver of GBP decline. A report late on Thursday suggests that the EU is threatening legal action after the UK government’s plans to override the Brexit treaty, which is a sharp escalation of tensions and which now leaves the trade deal talks in the balance. This has decimated GBP/USD, which has fallen some 600 pips so far this month. The technical indicators remain bearish for the pound, and if we see more risk aversion in the overall markets then the pound may decline further. A drop below $1.28 opens the way to $1.2720. Since the pound is moved by political factors, its future is binary. Either we get a healing of the tensions between the EU and UK and a clear signal that the trade talks are back on track, which could trigger a recovery in GBP/USD back towards its previous high of $1.34, or the talks break down further, the UK leaves the EU without a trade deal and GBP/ USD slides further. In the latter scenario we cannot rule out a move back to $1.20.