Dovish ECB sinks Euro, markets look to FOMC hike on Wednesday

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12 December 2016

thomasdodds

An unexpectedly dovish message from the European Central Bank’s (ECB) December meeting walloped the Euro last week.

T
he ECB’s nine-month extension of its asset purchasing program and a clear bias towards an even longer time frame mean that negative rates in the Eurozone will stay at least until 2018.

By contrast, the Federal Reserve is set to deliver an interest rate hike this week. We expect it to follow through with an upward revision of its expectations for the timetable of interest rate hikes in 2017. The previous ‘dot plot’ from the September meeting showed policymakers anticipated just two hikes next year (Figure 1), although we think this is slightly conservative.

Figure 1: FOMC September ‘dot plot’

As a result, widening interest rate differentials across the Atlantic is putting massive pressure on the Euro, which last week sold-off against every major peer.

Beyond G10 currencies, equities and credit continued to break into all-time highs. The celebratory mood extended to emerging market currencies. Latin American ones in particular enjoyed massive rallies against the Euro last week.

Major currencies in detail

GBP

Short-term measures of the health of the UK economy continue to paint a more positive picture than most had expected after the Brexit vote.

The PMI indices of business confidence continue to outperform expectations. At 55.2, the composite of manufacturing and services is consistent with GDP expansion closer to 3% than the 2% estimated previously. This likely means that the Bank of England will leave its policy unchanged when it meets this Thursday and that the underlying message will remain neutral to hawkish.

Together with a stronger than expected performance in both inflation and employment next week, we may see Sterling outperform against the Euro.

EUR

A trove of dovish surprises from the ECB last week sunk the Euro on Thursday.

First, the quantitative easing programme was extended by 9 months instead of the 6 expected by the market. Even though the amount of bonds purchased will be lowered from 80 billion Euros a month to 60 billion Euros a month after March, on balance the decision means that no fewer than 540 billion Euros worth of assets will be purchased versus the 480 billion Euros expected.

Another dovish surprise was the removal of the interest rate floor. The ECB will now be able to purchase bonds even if they yield less than the deposit rate, currently set at -0.4%. Further, the inflation forecast was left largely unchanged. Many economists had expected at least a modest upward revision.

Though more dovish than expected, this outcome does not substantially alter our outlook for a continued depreciation of the Euro, which we expect to break parity with the US Dollar at some point in the first quarter of 2017.

USD

Upward surprises in October durable goods orders and factory orders further support our view that the US economy is growing at a rapid rate, even before any Trump Administration fiscal stimulus or infrastructure spending starts.

While markets have fully priced in a 0.25% interest rate hike by the Federal Reserve on Wednesday this week, traders will carefully parse FOMC communications after the meeting. We believe that the critical piece of information will come from the ‘dot plot’, which summarises members’ view on the most likely future path of interest rates. We expect to see the first upward revision in such path in years.

We do not think that markets have priced in this development, and therefore we expect the meeting to provide further impulse to the Dollar rally against its major G10 peers.