The European Central Bank’s monetary policy announcement is the most important event risk on the calendar this week. Aside from the rate decision, the central bank also releases its latest economic projections which helps to shape future policy plans. ECB President Draghi is expected to remind investors that inflation is low, the economy is weak and easier monetary policy may be needed. Consumer spending has been particularly soft, manufacturing and trade activity took a hit after Brexit and most importantly, inflation remains well below target with year over year core CPI growth slipping to 0.8% from 0.9% in August. However there have also been areas of improvement namely in business confidence, German spending and German stocks. Some are hoping for more QE but at most we expect the ECB to extend its asset purchase program beyond March 2017.
As usual the EUR/USD there will be different phases to the currency pair’s post ECB reaction. First, if there is no new QE, EUR/USD will jump. Then the second and more sustained reaction of the day will depend on the ECB’s guidance and their staff forecasts – most likely these will be dovish which means weakness for the euro. However if there is no QE and Draghi stresses that they are in wait and see mode, the gains in EUR/USD will be sustained and of course if there is new QE, EUR/USD will drop to 1.11.
Here are my Main Takeaways from the June ECB Announcement and Mario Draghi’s Press Conference – will update if needed.
Top Takeaways from ECB
- ECB Hikes 2016 GDP and Inflation Forecasts
- More Stimulus on the way – Corporate Bond Purchases Begin June 8, TLTRO Begins June 22
- ECB Expects Extra Impetus from Stimulus Yet to Hit
- Low Oil Prices are Helping but Q2 Growth May be Slower than Q1
- Not Seeing Significant Wage Pressures of Second Round Inflation Effects
- ECB Still in Wait and See Mode – Needs to See Full Impact of Stimulus, Maintains Dovish Bias
- BUT If Financial Conditions Tighten Significantly, they Stand Ready to Act
- Global Economy and Brexit Main Risks for EZ
Thursday’s ECB meeting is one of the most important event risk this week. EURO has been biding its time trading between 1.1235 and 1.1475 pre-ECB. Which end of this range breaks hinges upon Mario Draghi’s tone. If he’s concerned about the strong euro and talks about the possibility of more stimulus, then 1.1235 could give. If he simply says they need more time to see the effects of stimulus and points to recent data improvements as a sign of their easing measures working, euro could break 1.1400 and aim for recent highs.
The following table shows how the eurozone economy changed since the ECB last met – from a data perspective, the central bank has less to worry about in April vs. March when there was significantly more deterioration than improvement. So the question is whether the 3 to 6 cent rise (depending where you’re measuring from) in EURO since easing rings alarm bells for the central bank.
Top Forex Themes for 2016
Since the next two weeks are generally the quietest periods in the financial markets, we want to take this opportunity to think longer term and share with you our currency forecasts for 2016. We’ll start with an initial review of the top themes and explore them in further detail as the week progresses in our outlook for each of the major currencies.
But first – 2015 has been a big year for the foreign exchange market. Divergences in monetary policies led to strong moves in currencies with the U.S. dollar as the best performer. The U.S. saw its first rate hike in nearly a decade while other major central banks in the Eurozone, China, Canada, Australia, New Zealand and Japan eased. In response, the greenback climbed to multiyear highs and this strength translated into significant weakness for many major currencies along with a collapse for commodities. These are some of the milestones reached in currencies this year:
The greatest risk for the financial markets and the global economy in the coming year is the feedback loop from the dollar and Fed policy.
While the quarter point hike in December represents only a nominal increase in U.S. rates, the Federal Reserve expects to tighten 4 additional times next year which will have broad ramifications for currencies, equities and commodities. In mid-December, we published a piece outlining the Consequences of a Strong Dollar and a lot of these issues will return to focus in 2016.
The first few months of the year should be good for the dollar as long as Fed officials don’t backtrack on their hawkish views.
There will be more hawks voting on the FOMC in 2016 than 2015 so the balance swings in favor of continued tightening. Between the warm El Nino weather and gas prices below $2.00 a gallon in some states, consumer spending should also rise in the first quarter. So while the dollar is rich, the path of least resistance is still in higher. However our outlook changes in the second half of 2016 as we believe rate hikes and the strong dollar will force the Fed to slow tightening makring the top for the greenback and the bottom for other major currencies.
Here are some of the themes that we are looking for in 2016:
Is Buying Dollars in 2016 a Smart or Foolish Trade?
2015 has been a great year for the U.S. dollar but with only 5 trading days left many investors are wondering if being long dollars in 2016 is still a smart trade. December has been a difficult month for the greenback with dollar bulls struggling to maintain control. The Federal Reserve raised interest rates for the first time since June 2006 but instead of appreciating, the dollar erased nearly all of November’s gains. Now many investors are wondering that if a rate hike and hawkish forward guidance can’t lift the dollar, is it foolish to be buying greenbacks in 2016.
To answer that question we have to understand why investors sold dollars in December. The bet that the dollar would rise in 2015 was one of the world’s most crowded trades and according to the CFTC’s Commitment of Traders report, forex futures traders were busy adjusting positions ahead of the December 16 FOMC meeting. The biggest changes were in euro and yen where investors aggressively cut their short euro and short yen positions. This means that investors started to unwind their long dollar trades ahead of FOMC and based on the price action after the meeting, liquidated further after the rate hike. Buying dollars became a very crowded trade in 2015 and a lot of money moved to the sidelines at the end of the year.
This means there’s money to put back into play in 2016.
Yet positioning was not the only reason why investors bailed out of the greenback. According to the following chart past tightening cycles have not been good for the dollar and this scared many investors. While USD/JPY generally appreciated leading up to the rate hike, on a number of occasions it reversed course after tightening but this cycle is different because the first few months of the year will be good for the U.S. economy and the dollar. The warm El Nino weather and low gas prices will boost consumer consumption, which is already supported by steady job creation, wage growth and consumer borrowing. The Fed also welcomes new hawks to their roster of FOMC voters.