While there was a whole lot of volatility around the ECB meeting, can we really say that the policies or the statements from Draghi were surprising? The thing that moved the markets hardest was Draghi’s admission that there were no plans to take further action, and there was a limit to how far the ECB were prepared to cut rates into negative territory. But it is bizarre that the markets should think that the ECB, having announced a wide ranging package of aggressive stimulus measures, largely unconventional, should already be contemplating more. To do so would be to admit that failure is likely, which they are hardly going to do (even if the market probably thinks it is). That there is a downside limit to the usefulness of negative rates is also hardly news. Without tiering – which would mitigate the effect of more negative rates on banks and allow them to avoid passing negative rates on to retail customers for longer – the ability of the public to hold cash in preference to a negative yielding bank account provides an obvious downside limit for rates.
So what are we to make of the huge EUR/USD rally? One view is that it provides a massive opportunity for EUR bears. The T-note/bund spread that has been the best guide to EUR/USD over the last year or so has risen further and at 170bps suggests scope to move back down to around 1.0750 (see chart). However, after another bruising encounter with the ECB, the USD bulls may be starting to lose some confidence, so I doubt we will see a rapid move back down to test 1.08, at least until we see some more compelling evidence that the US economy is flourishing and the Fed are set to hike again in June.
However, there may also be some concern that the underlying drivers of EUR/USD may be starting to change a little. The massive Eurozone current account surplus has, for much of the last year, been overwhelmed by the capital outflow from the Eurozone. But even though yields in the Eurozone are unattractive, any loss of confidence in the likelihood of further EUR weakness will limit the enthusiasm of Eurozone investors to put money abroad, especially when there isn’t a huge amount of confidence in growth elsewhere. The lack of any real enthusiasm from Draghi to force the EUR down (illustrated by the lack of tiering which would have allowed still more negative rates, and the highlighting of the “solemn” G20 agreement) will probably further undermine investors’ belief in future EUR weakness.
Nevertheless, I would favour the EUR drifting lower for now, back toward the 1.10 area which is essentially the middle of the current 1.08-1.12 range (1.05-1.15 on the wide). But there is a feel that a sea change may be in the offing in the FX markets , so I wouldn’t get too committed to EUR shorts here. Big picture, you have to remember that these are cheap levels to buy EUR if the ECB’s policies prove successful.
A simpler trade for the USD bulls here may be to sell GBP/USD. Considerations about the Eurozone’s current account surplus don’t apply to the UK – indeed the opposite is true give the big UK deficit. At current yield spreads there also doesn’t look to be any Brexit premium in GBP/USD – so any poll movement in favour of the leave camp in the coming months (and I’m pretty sure there will be one, even though I suspect that in the end the UK will vote to stay) could cause a sharp GBP decline. Even without it, the uncertainty surrounding to issue seems to limit the upside for GBP now the majority of the short GBP positions have probably been squared. Additionally, the upcoming Budget may see more fiscal tightening that further reduces the chance of any monetary tightening this year. GBP/USD is in any case likely to decline if EUR/USD slips back. And while the risk positive market tone and the strong oil price have helped give GBP some support in recent sessions, the big picture truth is that the oil price is still very low here and there is in any case no real risk premium in GBP to account for the decline in oil. Commodity producers listed on FTSE may attract some capital inflow if commodity prices continue to recover, but I wouldn’t see this as the basis for a sustainable GBP recovery. Finally, it is important to remember that while GBP/USD looks low by recent standards, in real terms 1.44 now is equivalent to about 1.58 in 2008 because of high UK inflation in the intervening period.