Fade the EUR/USD's Draghi Bounce

© European Central Bank

- Euro's Draghi-induced gains built on sand say Commerzbank. 

- Draghi's statements all based on assumptions and forecasts.

- The actual inflation picture is contradicting Draghi's optimism.

The Euro has shifted onto the front foot this week after European Central Bank (ECB) chief Mario Draghi sounded an optimistic tone about the continental inflation outlook but the single currency's rise is unlikely to last for very long, according to analysts at Commerzbank

Europe's consumer price outlook has improved in recent months and core inflation, which removes volatile commodity items from the goods basket and so is thought to provide a better reflection of domestically generated price pressures, is set to reach 1.8% by the end of 2020 according to Mario Draghi's testimony to the European parliament

"Annual rates of HICP inflation are likely to hover around current levels in the coming months and are projected to reach 1.7% in each year between now and 2020. This stable profile conceals a slowing contribution from the non-core components of the general index, and a relatively vigorous pick-up in underlying inflation," Draghi told a parliamentary committee. 

This would leave the rate of core inflation at the ECB's target of "close to but below 2%" and vindicate the central bank for its decision to cut the amount of government bonds it buys each month to €15 billion at the end of September, before reducing its purchases to zero in December. Interest rates are still to "remain at their present levels at least through the summer of 2019".

The Euro was shocked back into life during the Monday session as a result of Draghi's statements, with the currency rising back toward its three-month high just above 1.18. However, some analysts have been quick to call out the market response as misguided. The reaction Tuesday from Germany's Commerzbank is a case in point.

"Some people just hear what they want to hear. That was the case yesterday when the euro traded at stronger levels after markets heard the words “vigorous pick-up” in connection with inflation in the euro zone from ECB President Mario Draghi. What a shame Draghi was not referring to the current inflation trend but only the assumptions on which the ECB’s longer term forecasts are based," says Thu Lan Nguyen, an analyst at Commerzbank. 

Nguyen and the Commerzbank team say the market has taken Mario Draghi's comments on inflation out of context and that they could, or perhaps should, even have been interpreted as "dovish" remarks. This is because the continent's actual inflation trend is challenging the European Central Bank's optimism. 

Eurozone inflation declined to 2% in August, down from 2.1% previously, while the core rate of inflation also dropped by 10 basis points to 1%. Although the headline inflation measure has risen back above 2% this year, aided by a double-digit increase in the price of oil, consumer price numbers have surprised on the downside repeatedly in 2018.  

Markets had looked for both to hold steady at their July levels last month but were thwarted this time by changes in energy prices as well as weakness in price growth for goods and some services across the bloc. 

"Even if yesterday’s reaction was unjustified and was therefore corrected again quite quickly it nonetheless illustrated what matters to the market at present. What matters is the moment when the ECB changes from passive to active monetary policy, or to be precise the moment when it starts using interest rate policy to control inflation once again. The condition for it to do so would obviously be a rise in inflation momentum to which it can react," Nguyen writes, in a briefing to clients Tuesday.

The European Central Bank has been fighting against below-target inflation and weakening price pressures ever since the middle of 2012, around the time the Eurozone debt crisis began to dissipate. It is required by law to use monetary policies in order to ensure the consumer price index remains at its target of "close to but below 2%".

This mandate has seen the ECB cut interest rates below zero and use other policies like quantitative easing in order foment a recovery of inflation, which normally occurs as a result of faster economic activity that is itself thought to result from the reduction in borrowing costs. 

However, Eurozone CPI fell from 2.7% in September 2012 to a low of -0.6% in January 2015. It has since risen back to 2% on a number of occasions, notably in March and April 2017, only to go once again into retreat immediately after. Core inflation, the truer measure of domestic price pressures, has never made it above 1.2% in all that time. 

With inflation and interest rates both now rising elsewhere in the world, the ECB may be keen to begin normalising its monetary policy so as not to get left behind. Changes in interest rates impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"Base effects in oil prices suggest that energy inflation will fall further, pulling the overall headline down towards 1.6% at the end of the year. The core rate should edge higher to about 1.3%, but risks are tilted to the downside given still-low goods inflation and a number of one-off factors depressing inflation in services, mainly German education services and French rents," says Claus Vistesen, chief European economist at Pantheon Macroeconomics, in an August note to clients.

Nguyen and the Commerzbank team say these weak inflation pressures, and their implications for the European Central Bank, will keep the Euro-to-Dollar rate under pressure well into the first-quarter of 2019. They forecast EUR/USD will finish 2018 at 1.16, before rising to 1.18 by March 2019 and 1.26 before the end of next year.


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