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ECB Minutes Trigger Euro Rally

ECB sends the Euro soaring against the Pound

Above: ECB President Mario Draghi and his team are comfortable with the trajectory of inflation in the Eurozone. (C) ECB

The Euro is on a firm footing, particularly against Sterling, although some doubt this can continue. Progress in German coalition talks might see doubters proven wrong.

The Euro is outperforming its peers after the European Central Bank caught markets by surprise with the release of December’s meeting minutes.

Europe’s currency was bid higher after the minutes made clear there "is a clear probability that we will see the bank prepare the markets for the end of their huge stimulus scheme," observes Joshua Mahony, a Market Analyst at IG.

The Euro rose through 2017 as traders increasingly anticipated this shift in stance and Friday’s reaction confirms the ECB remains a key driver of Euro strength.

The Pound-to-Euro exchange rate fell below the 1.13 level to a low of 1.1219 in the wake of the release, and remained there during early trading Friday. The exchange rate started the week at 1.1274.

European policymakers saw "some comfort" in wage dynamics, according to the minutes, but low inflation remains a concern.

Significantly, they flag that a gradual shift in forward guidance could be forthcoming “in early 2018" if price pressures do pick up, which suggests rate setters have grown less dovish since their decision to cut bond purchases in October.

"These brief comments sent EUR/USD soaring 100 pips in a matter of hours and shifted the near term outlook for the euro. The single currency is poised for a move up to 1.21 versus the U.S. dollar and could extend those gains if Friday's U.S. economic reports fall short of expectations," says Kathy Lien, Director at BK Asset Management in New York.

Lien proved correct as the EUR/USD rate did break above the 1.2100 level during early trading Friday and the outlook for the common currency has indeed shifted into a more positive mode.

This means the Pound-to-Euro exchange rate could come under more pressure and move towards the bottom of its current medium-term range around the 1.11 level.

Above: Pound-to-Euro exchange rate shown at daily intervals.

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Market Now Looking for a European Rate Hike?

Richard Grace, chief strategist at Commonwealth Bank of Australia, identifies the two most notable points supporting a bullish EUR outlook.

(1) “Incoming information and the December 2017 staff projections indicated a significant improvement in the growth outlook and continued economic expansion at a pace exceeding potential. Risks to the growth outlook continued to be balanced, with some upside risks in the near term.”

(2) “Looking ahead, the view was widely shared among members that the Governing Council’s communication would need to evolve gradually, without a change in sequencing, if the economy continued to expand and inflation converged further towards the Governing Council’s aim.

The language pertaining to various dimensions of the monetary policy stance and forward guidance could be revisited early in the coming year. In particular, as progress was made towards a sustained adjustment in the path of inflation, the relative importance of the forward guidance on policy rates would increase.”

Like most others, Grace says the Euro could continue appreciating during the months and quarters ahead. There aren’t many who do not forecast the common currency to sit above the 1.20 level by year end and some even say it will be closer to 1.30.

"With the Euro rising to a 3-year high against the US dollar, it's worth reiterating that the ECB's path of least resistance will be a gradual rally in towards 1.30," writes Viraj Patel, a strategist at ING Group, in a note Friday.

 

A Minority Say the Recent Boost Won't Last

Not everybody in the class is convinced that the current current burst of Euro strength can continue in the short term.

“Yesterday’s developments fuelled speculation that the ECB will end its asset purchasing programme in September, so that the first rate hikes could follow at the end of the year. The likelihood of a rate hike in December priced in by the market jumped well above 50% providing good support to the euro and allowing EUR-USD to climb back above the 1.20 mark. However, in my view yesterday’s market reaction was exaggerated for two reasons,” says Thu Lan Nguyen, an analyst at Commerzbank.

Nguyen flags that much of the evolution in the ECB’s policy stance is the result of a strong pickup in Eurozone economic growth, which is forecast to have reached its highest level since 2011 during the recent year. Fourth quarter data will be released this month.

However, the rub for the Euro is that optimism over economic growth alone will not be enough to lift Eurozone inflation, which is languishing some way below its 2% target, at around 1.4%.

Monetary policy decisions are made in response to changes in inflation and economic growth only matters to the extent that it is able to influence inflation.

Without higher inflation, interest rates cannot rise, but much of the developed world has enjoyed sustained growth similar to that seen in the Eurozone currently - without seeing much of a meaningful increase in inflation during recent years.

The more important measure of “core inflation”, which removes volatile commodity prices from the comparison and so is seen as more representative of true domestic price pressures, has languished beneath 1% in Europe throughout the entire fourth quarter.

In addition, the European Central Bank has stressed in the past that interest rates will remain at their record low levels until “well past the end of net asset purchases”.

But current market pricing suggests there is a 50% chance of a rate hike this December already baked into the Euro exchange rate. This could be a recipe for market disappointment and decline if inflation remains lacklustre throughout the year ahead.

“Short term EUR-USD is likely to continue to enjoy its excursion into higher regions though,” says Nguyen. “However, sooner or later the realisation that monetary policy in the eurozone will remain expansionary for much longer than hoped will bring EUR-USD back down to earth.”

Readers can learn more about what others are forecasting for the Euro in 2018 here. A compilation of major bank forecasts and currency views for the Pound-to-Euro rate is available here

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German Coalition Agreement takes a Step Closer

Another factor that might help provide the Euro with a continued boost in the short term is German politics and the slow march of its politicians toward a governing coalition.

Friday’s reports indicate Chancellor Angela Merkel’s Christian Democratic Union has struck an agreement with the Social Democratic Party of Germany that enables talks over a possible “grand coalition” government to begin.

Preliminary talks ended Friday with reports from Reuters suggesting both parties had agreed to support French President Emmanuel Macron in his bid to support the Eurozone with more shared budgets and to drive greater integration of the bloc’s members.

President Macron has previously called for fiscal federalisation in order to support the monetary union, which would see the creation of a Eurozone finance minister and a common budget.

A question mark remains over the extent to which German politicians will be willing to support some of the plans given the German electorate’s opposition to debt mutualisation.

However, markets see such integration as clear positive for the currency and the Eurozone economy so any signs of progress on further integration could see the Euro rewarded with a stronger bid in the weeks ahead.

With the “blueprint” or roadmap for coalition discussions now agreed, formal talks are expected to begin toward the end of January.

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