Euro Choppy against Dollar and Pound after ECB Sets Stage for Rate Cuts and QE from September

© European Central Bank

- EUR choppy  after ECB lays groundwork for rate cuts and QE.

- All rates remain unchanged in August, action seen in September.

- Says growth outlook getting "worse and worse", pledges action.

- But EUR outlook remains clouded ahead of July 31 Fed decision.

The Euro saw choppy trading against the Dollar and Pound Thursday after the European Central Bank (ECB) set the stage for interest rate cuts and a reopening of its bond buying program from September, as it seeks to lift already-insufficient inflation pressures at a time when economic growth is weakening

ECB officials left the refinancing rate, marginal lending rate and deposit rate unchanged at 0%, 0.25% and -0.4% respectively Thursday, although the bank said it's tasked staff with devising a "tiered system for reserve remuneration" and considering "options for the size and composition" of a new quantitative easing program. 

References to a "tiered" system for reserve remuneration suggest the ECB is on the verge of cutting its deposit rate further below zero, because talks of such a thing has always been in reference to protecting the already-weak profitability of commercial banks from the effect of negative rate charges on their reserves. 

The ECB was already expected to begin a new round of targeted-long-term-refinancing-operations in September, which will provide commercial banks  with cheap cash in an effort to boost lending to companies and consumers.

"The ECB never pre-commits. But this is as close at it gets. When the central bank convenes in September, it will be looking at poor Q2 GDP data, and core inflation that almost surely will be virtually unchanged from its current trend of about 1-to-1.2%. In short; further easing is on the way," says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics.

ECB President Mario Draghi says the Governing Council still sees signs of strength in the economy, particularly in the services sector, but also he also admitted the economic outlook is getting "worse and worse". He singled out manufacturing and those countries where manufacturing is important for growth a suffering the greatest.

Thursday's decision follows a period of mounting speculation suggesting the ECB will take radical action sooner rather than later. That speculation was encouraged by a growth slowdown brought on by the U.S. trade war with China and multiple uncertainties that are crimping activity in Europe. Draghi also acknowledged Thursday that the economic rebound anticipated by the ECB for the second half of the year is now looking less likely. This deterioration is happening amid persistent weakness in inflation.

"We’ll let traders do the trading, but if you’re buying EURUSD, and selling bonds, because you think the risk of easing in September has diminished after this press conference, don’t! We are very confident that today’s message from the central bank is that they’ll do more," Vistesen adds.

Above: EUR/USD rate at hourly intervals, alongside the Pound-to-Euro rate (green line, left axis).

"The last talk before the ECB will have to walk the walk. It now increasingly looks as if the September meeting will not only bring a single measure but rather a package of several measures," says Carsten Brzeski at ING.

The influential Institute for Economic Research warned Thursday on the outlook for the troubled German economy, which is expected to have slowed in the second and third quarters, alongside the Eurozone. Eurozone GDP growth fell from 2.3% to 1.8% in 2018 and the European Commission forecasts it'll decline to 1.2% this year. Those developments have come at a bad time for the ECB. 

"Both the current conditions and business expectations indices declined, despite mounting speculation about looser ECB policy which has supported equity prices and pushed bond yields down. And the fall was also broad-based across sectors, with the business climate deteriorating in manufacturing, trade, and services," says Jack Allen-Reynolds at Capital Economics.

This came after IHS Markit PMI data suggested the ongoing recession in the German manufacturing sector may have deepened in July, which is now threatening to see the Eurozone's largest economy continue its recent underperformance in the third quarter. What's more, some economists are also growing concerned that the industrial downturn could soon begin to cost jobs, which would further threaten the economy. 

Eurozone inflation has fallen from 1.4% in January, to 1.3% in June this year while the more important 'core' measure of inflation has remained at 1.1%. The main inflation rate is down from 1.8% in January 2018, although the core rate is up 0.1% from its 2018 level. All of these numbers are a long way off where the ECB needs them to be, even after its past efforts to stimulate the economy.

Now, analysts and financial markets are busy speculating over what it might do next in order to revive the Eurozone's inflation pulse. 

Above: EUR/USD rate at daily intervals, alongside the Pound-to-Euro rate (green line, left axis).

The ECB has already cut the rate it charges commercial banks to park money with it to -0.4%, reduced its lending rate to zero and spent up to €80 bn per month over the three years ending in December 2018 as part of an effort to lift inflation by stimulating economic growth. It bought European bonds en masse, forcing down their yields as well as borrowing costs for some companies. 

Changes in interest rates are normally only made in response to movements in inflation, which is sensitive to growth, but impact currencies because of the push and pull influence they have over capital flows. Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

The prospect of ECB rate cuts and quantitative easing should be bad for the Euro. However, There's uncertainty over what all of this will mean for the single currency in the short-term because the Federal Reserve (Fed) is also expected to cut U.S. interest rates steeply too. And the Fed, with an interest rate of 2.5%, has much more scope to cut borrowing costs than the ECB does. 

That could result in the U.S. Dollar falling further than the Euro, which means a rising Euro-to-Dollar rate, even cheaper imports from America and even less of an inflation pulse than exists currently. That's unless of course the ECB takes radical action at some stage in order to weaken the Euro while the Federal Reserve takes an axe to its own benchmark borrowing cost. 

Above: EUR/USD rate at weekly intervals, alongside the Pound-to-Euro rate (green line, left axis).

"In truth, the ECB is down to a couple of pea-shooters. The days of “whatever it takes” are long gone. Fiscal policy needs to engage. We'll take our cue from the bond market, but I doubt that anything the ECB does/says provides much comfort," says Kit Juckes, chief FX strategist at Societe Generale.

ECB "staff" were said last Thursday to be looking at updating the inflation target that dictates the central bank's interest rate policy after years of failed attempts to use monetary stimulus to get the consumer price index sustainably above the "close to, but below 2%" threshold. 

That could see the ECB keep rates low while inflation overshoots the target by as much and for as long as the consumer price index has undershot it. Barring a few brief periods resulting from increases in the price of oil, Eurozone inflation has been below 2% for much of the time since 2012. 

Earlier reports followed repeated references to the "symmetric" nature of the target by ECB officials in recent months and has prompted some analysts to contemplate whether the bank is about to formally declare the target such. 

Any decision to move to a "symmetric" target would mean interest rates move lower and remain lower for much longer than the markets currently anticipate. Pricing in the overnight-index-swap market indicates investors expect rates to fall 0.25% over the next year but return to current levels early 2021. 

"The ECB’s broader commentary on its inflation problem and its determination to address was stark. It ‘underlined the need for a highly accommodative stance of monetary policy for a prolonged period of time, as inflation rates, both realised and projected, have been persistently below levels that are in line with its aim’. In addition, it stressed ‘its commitment to symmetry in the inflation aim’. These comments suggest that net asset purchases could ultimately persist through 2020," says Nick Kounis at ABN Amro.


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