Daily Market Update: Euro drops by nearly 2% as Draghi signals ECB likely to provide more stimulus in December
Speculation has been building for some time that the ECB may end up needing to inject additional stimulus into the euro zone economy in order to boost the prospects of a return to target levels of inflation.
And even though market expectations for a signal from yesterday’s policy update were reasonably high, Draghi managed to exceed those lofty expectations by providing a pretty clear and explicit signal that the ECB may well unveil additional stimulus at its next meeting on December 3rd.
While Draghi noted that domestic demand in the euro zone has remained resilient, he indicated that “concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation”. He highlighted that the ECB is analysing the “strength and persistence of the factors that are currently slowing the return of inflation” to the target of close to but below 2%, and that in this context, the “degree of monetary policy accommodation will need to be reexamined at our December monetary policy meeting”.
While the reference to possible action in December is clearly couched in terms of the need for further “thorough analysis” of inflation dynamics and a yet-to-be-conducted assessment of the appropriateness of the policy stance, Draghi fully understands that the signal he provided yesterday would be interpreted as a strong endorsement of market expectations for further stimulus. Moreover, the Q&A segment of the press conference brought the revelation that the option of a further reduction in interest rates (he explicitly mentioned a possible further lowering of the deposit rate – currently at - 0.2%) was now also back on the table. This represents important new news for markets as Draghi had previously explicitly said that rates that had reached their lower bound. It also means that the next bout of stimulus could feature use of the interest rate tool as well as the much-speculated upon expansion/extension of the QE programme, thus further reinforcing the dovish tone.
And unsurprisingly, the price action since the meeting indeed confirms that markets are very much running with the very dovish messages provided by the ECB president yesterday. Notably, equity markets are up strongly (the Euro Stoxx 50 is up about 4%) while bond yields and market interest rates in the euro zone are markedly lower: 5-year swap rates are down 5bps, while 10-year government bond yields are down 10bps and more in many countries, including in Ireland where yields are now again closing in on the 1% level, at 1.07% this morning. And this downward pressure on euro rates and yields is having the expected (and desired) effect on the euro’s value on the foreign exchange markets, with the single currency down about 2% against both the dollar and the pound opening at $1.1110 and 72.1p respectively.
We regard yesterday’s update from Draghi as important encouragement for our view that policy divergence is set to remain an important theme for currency markets as we look ahead. ECB stimulus provision stands in marked contrast to the likely tightening of Fed and BoE policy in the months and quarters ahead and we reiterate our view that the euro is set to weaken on those timelines. We continue to target $1.06 in Eur/USD and 69.5p in Eur/Stg, with the extent and timing of further euro weakness ultimately depending not just on the scale and form of ECB action, but also on a firming of rate hike expectations in the US and UK. While Draghi’s update has understandably received huge attention, there was another development of interest yesterday at lunchtime which came in the form of the latest jobless claims numbers from the US. These showed the 4-week average of claims at their lowest level since 1973! We regard this as an important indication of ongoing improvement in the US jobs market and, in our view, serves to challenge current pricing in US interest rate markets, which doesn’t have the first rate hike fully priced in until July of next year. This is a set of expectations that to us looks vulnerable to a (dollar-positive) correction.