Euro bulls' days may be numbered
- ECB chief Draghi hints at euro declines
- Banks see US inflation on the horizon
- Chinese exports show pronounced drop
By Neil Staines
At the Economic Club of New York last Friday evening, European Central Bank president Mario Draghi was questioned by former Bank of England governor Mervyn King, among others, with specific reference to the ECB’s recent decisions and perhaps more pointedly, the market's reaction.
While his words were interesting, it is possible that his inferences were even more so. Draghi was clear to point out the strength and depth of the measures that had been implemented by the ECB. Above all, he stated that the pledge to reinvest principal payments – in addition to the extension of the quantitative easing programme to “at least” the end of March 2017 – would add a further €680 billion, or some 6.5% of euro area GDP, into the liquidity system by 2019.
However, Draghi also made it clear that the exchange rate helps to transmit ECB policies. Following last Thursday's ECB decision and subsequenct press conference, EURUSD saw its largest one-day rise since the Federal Reserve first initiated its money printing programme (QE1), notwithstanding the fact that the ECB had actually eased policy.
While Draghi’s told his New York audience that the main monetary policy tool is now the ECB balance sheet, his inference (at least as I saw it) was that this should bring EUR lower.
As the market’s attention turns towards the end of an extremely complex and uncertain year, it is perhaps not surprising that participation and liquidity has continued to decline since Thursday’s ECB announcement. There are, however, a number of events that warrant close attention as we head into 2016.
The first is clearly the December 16 US Federal Open Market Committee meeting where a rate hike is all but “baked in” after the further substantial improvements in labour market dynamics and service sector activity (notwithstanding the fact that manufacturing continues to disappoint).
The main focus of market attention will thus be on any suggestion or inference as to the likely pace of tightening through 2016 and what that means for the interest rate curves and differentials, equity valuations and the USD.
A number of global banks have recently suggested that as the US unemployment rate will go below its natural (or NAIRU) rate in 2016, the prospects for inflation (yes – inflation!) will rise. Breakeven rates in the US have already started to rise. This view concerning the unexpected threat of inflation is one that we have discussed previously and one we continue to hold.
The second is perhaps less of an event, but more of a potential threat. We have mentioned the overhang, or disequilibrium, in USD funding a number of times and it has been both increasingly evident in the cross-currency basis swap (relative to a range of currencies) and increasingly visible in short-dated USD fixes and reverse repo markets.
It is our view that this USD funding shortage will be exacerbated into the final weeks of the year and, as such, will likely drive demand for USD, most acutely in emerging markets.
At the start of last week, we discussed the inclusion of the yuan into the International Monetary Fund's Special Drawing Rights basket and how, in the near term, this accomplishment may well be met with a further weakening of the currency.
The release of trade and FX reserve data over the past 24 hours suggests that the case for further CNH weakness may be increasing. The data showed a ¤87.2 billion fall in China’s FX reserves (to their lowest level in two years) – a decline that was significantly bigger than expected, even if about half of this is due to FX revaluations.
Furthermore, this morning’s trade data highlighted continued economic fragility as exports fell faster than expected, to negative 6.8% year-over-year.
Neil Staines is head of trading at The ECU Group