Euro in countdown to key Fed call on interest rates

The euro rebounded strongly towards the end of last week as the latest raft of ECB easing measures failed to live up to market expectations writes Oliver Mangan,Chief Economist atAIB.

The ECB cut the deposit rate by a further 10bps, moving it deeper into negative territory at -0.3%. However, a bigger cut had been expected. The ECB also announced changes to its quantitative easing bond-buying programme but again the measures fell short of market expectations.

The duration of the programme was extended to March 2017, or beyond, if necessary, from the original proposed end date of September 2016. The ECB also stated that it would reinvest the principal payments on the securities purchased when they mature.

It also announced that it was broadening the spectrum of bonds it can purchase as part of its public sector bond buying, to include euro denominated debt issued by regional and local governments in the eurozone. Crucially, though, there was no increase in the size of the monthly purchases of €60bn under the bond-buying programme.

There had been talk in the market that this would be raised to between €75bn and €80bn per month. The policy changes did not receive unanimous support on the Governing Council, indicating that there was some opposition within the ECB to an aggressive easing of policy. This may well be the reason why the measures disappointed expectations.

It seems that the ECB president Mario Draghi opted for more modest changes that could command greater support on the council. The ECB indicated that it was providing the additional monetary stimulus in order to secure a return of inflation towards levels that are below, but close to 2%. Mr Draghi emphasised that the easing measures will need time to be fully felt and that there is still a willingness within the ECB to do more, if required.

Thus, the ECB retains an easing bias. It is worth noting that a number of other European central banks have even lower deposit rates than the ECB, so there is room to do more, if needed. However, as already noted, it is quite clear, judging by the market reaction, that, on this occasion, the ECB under-delivered compared to market expectations.

The disappointment was evident across all financial markets. Eurozone bond yields rose, with 10-year German bund yields increased by 25bps to 0.7%. Meanwhile, European equity markets sold off, with the Euro Stoxx index down 3.6% on the day. The most notable action, though, was on the currency markets, where the euro rose sharply.

After starting the day just below $1.06, the euro bolted higher after the ECB announcement, to within touching distance of $1.10, before settling down above $1.09. It was the euro’s biggest one day gain since 2009. Meanwhile, the euro, which has been trading against sterling around 70 pence, rose above 72p. These moves should be seen in the context of the marked fall of the euro in the weeks leading up to the ECB meeting.

The euro fell from a high of $1.15 in mid-October to below $1.06 while, against sterling, it fell from near the 75p level to 70p. Thus, it has only recouped some of the losses of the past few weeks. The risks remain to the downside for the euro, given the prospect of rising interest rates in the US over the coming year, at a time when short-term rates in the eurozone look set to remain quite negative.

Sizeable negative interest rate differentials seem likely to act as a headwind for the single currency in 2016. It is hard to see how the euro can make gains against the dollar next year if the Fed is raising rates, even at a very gradual pace. Instead, against the dollar, the euro seems more likely to fall back towards the key support level of $1.05 in 2016.

The one hope for the euro may be if the Fed decides to increase rates only very slightly to 0.25% at its meeting next week and indicates that any rate rises will be very small, indeed, in 2016. However, futures contracts suggest that the Fed could raise rates by 75bps in the next 12 months. Such a development is likely to see the dollar make gains against most currencies, including the euro, in 2016.