- Draghi successfully raises guidance without pressuring the euro
- Euro optimism likely to return next year as negative interest rates go out of fashion
- Prevailing conditions are an ideal backdrop for the euro
Front-running changes in monetary policy is a popular trading strategy amongst foreign exchange traders. This year, euro traders successfully bid up the value of the euro ahead of the ECB’s tapering announcement in October. Looking at trading for Euro to US dollar, the pair made its highs in early September and sold off following the event. Prior to the ECB’s rate decision and statement this week, many were betting that ECB President Mario Draghi will adopt a more hawkish outlook by signaling a possible change of plan. As Eurozone GDP growth strengthens while political risks subside, expectations are building for the Bank to reduce the scope of monetary stimulus.
Draghi tames the euro bulls
While Draghi acknowledged the brighter outlook for economic growth in 2018, the ECB’s forecast for inflation next year remains moribund. Looking at the latest update, the forecast for GDP growth was raised to 2.3% (from 1.8% previously) while inflation was raised to 1.4% (versus 1.2% previously). With inflation set to remain far below the Bank’s 2% target rate, the ECB is in no hurry to signal any change in monetary policy. In Draghi’s words “All in all the revision of the macroeconomic projections is going in the right direction, [but] an ample degree of monetary stimulus remains necessary.”
By raising the growth forecast while keeping inflation expectations low, the ECB has managed to improve the future outlook without any associated strength in the euro. For supporters, the ECB can point to strong GDP growth as evidence that the current easing program has helped fuel an economic recovery. For critics, the Bank can point to low inflation as reasons to maintain ‘easy money’ policies. In short, the last ECB meeting had something for everyone.
Euro optimism to return next year
Assuming growth and politics in the Eurozone remain stable, expect another euro rally towards the second-half of next year. This time, euro traders will be betting on the end of negative interest rates. As the end of quantitative easing is mostly priced into the euro today, the next big event will be with regards to changes in the ECB’s deposit rate. Following Draghi’s “greater confidence” that inflation will approach the Bank’s target rate next year, the ECB will struggle to justify negative rates which are particularly harmful for the Eurozone’s weak banking system.
Euro bull market still intact
The euro rally that began with Macron’s victory in the French presidential elections remain intact. Within the EU, political risks including the Catalonian independence movement and German coalition talks have only had a limited impact on the common currency. In Italy, the success of pro-European Union parties in regional elections suggests a more benign outlook for national elections in March.
Looking outside the EU, strong growth and weak inflation has historically been the ideal background for the common currency. Given strong GDP growth in the US, the Eurozone and Japan, the prospects of an economic crisis are fairly remote today. Meanwhile, as inflation is likely to decelerate in the future, the threat of a US dollar rally (the primary external driver for euro weakness) is also unlikely. While these trends won’t last forever, the euro rally looks set to continue.