EUR Labors Ahead of ECB and NFP – Is There More Room to Fall?

This is expected to be a tough week for investors. Central bank rate decisions mixed in with North American jobs reports will dominate the capital markets risk landscape. Thus far, it’s no surprise to see European markets maintain a cautious tone after the North American long holiday weekend. Investors are keeping an eye on the lingering conflict in Ukraine while trying to gauge European Central Bank (ECB) intentions on how it will introduce further stimulus measures later this week. Even the EUR and RUB are broadly unchanged outright, and this is in stark contrast to yesterday’s selloff which saw the currencies hit upon new multi-year record lows. The market has been waiting to see what North America wants to do.

Thus far, many investors, via intraday trading, have been mostly influenced by geopolitical events. Nevertheless, many of the market’s participants will now turn to the ECB and the possibility of witnessing further rates cuts to stimulate the eurozone’s sluggish recovery for guidance. The market has some of this already priced in — maybe the EUR will catch a bid on ‘fact’?

The Pressure on the ECB Mounts

From an investor’s standpoint, this is a ‘big’ call for ECB President Mario Draghi and company this week. Quantitative easing (QE) is considered to be the last resort the bank can lean on. Structurally, Europe is not ready to dive headlong into buying asset-backed securities. However, the ECB has been cornered when it comes to growth and inflation. With both elements struggling, can the euro region continue to wait patiently for lower base rates and the targeted longer-term refinancing operation (TLTRO) to kick in before implementing QE?

QE is untested and it will not necessarily weaken the EUR to the desired levels called for by the eurozone’s struggling members, in particular France. It’s a huge gamble for policymakers since it might not work and Europe will remain in a low-growth, high unemployment state. Many expect that when the ECB does eventually launch QE, it will be able to guide the EUR/USD toward €1.20. Investors should be aware that QE does not always guarantee currency weakness. When the Bank of England (BoE) first implemented the practice, the pound actually appreciated when the BoE was buying gilts. The strength of the 18-member single unit will depend on what investors will be anticipating. If they expect higher asset prices after QE, then overseas investors will be demanding EURs to invest in European assets to capture some of that capital appreciation — eventually it will weaken.

The benefits of another modest rate cut could be marginal now that the deposit rate is already in negative territory. The weaker EUR (€1.3118), negative money market rates, and lower bond yields already suggest that the ECB can afford to be patient to wait-and-see the effectiveness of September’s and December’s TLTROs before embarking on further credit easing. Many would probably view a token cut to base rates as an act of desperation by ECB policymakers to kick-start the low inflation dilemma. The ECB is expected to use the remaining few months in the calendar year to access the credit scheme’s powers, while stepping up pressure on regional politicians to deliver “pro-growth” structural reforms. The purchases of sovereign bonds remain high, but which ones? Nevertheless, credit easing by way of asset-backed securities purchases could be structurally up and running by year-end, making it easier for the ECB to decide what it should do.

The mighty dollar has enjoyed most of the market’s support over the summer months, jumping to a seven-month high against JPY earlier this morning (¥104.90). There is much expectation that U.S. monetary stimulus policy is near an end (QE is expected to finish by October), while a cabinet re-shuffle in Tokyo and a potential delay to Japan’s next sales tax hike could help improve the twin problems of growth and lack of inflation on the island nation. The dollar continues to be supported by improving consumer confidence metrics and a stronger jobs market. This Friday’s nonfarm payrolls data will be able to provide the current lay of the land when it comes to the state of U.S. employment.

Scottish Independence Weighs on Sterling

In contrast to yesterday’s disappointing U.K. manufacturing reading (52.5 versus 55.5), this morning’s U.K. construction purchasing managers’ index for last month pointed to a continued acceleration in the sector (64 versus 61.5), as it managed to reach the highest level in seven months. The pound should have gathered support on the headline; nevertheless GBP (£1.6525) came under political pressure after a narrowing in the opinion polls ahead of the Scottish independence vote on September 18. Even the two-member Monetary Policy Committee dissent will be incapable of getting in the way of politics. The BoE is expected to remain on hold this coming Thursday but perhaps it will add more color on last month’s dissenting views.

Supply pressures and profit-taking ahead of big event risks later in the week are leaning on the fixed-income markets, pushing both Bund and gilt 10’s down and steepening the curves after a few weeks of curve flatteners.

RBA Leaves Interest Rates on Hold

The Aussies did what was expected of them in the overnight session. The Reserve Bank of Australia (RBA) kept the official cash rate at a record low of +2.50%, as widely expected. The central bank again forecast no moves for a period of time (AUD$0.9287). Although the RBA said there has been some improvement in indicators for the labor market this year, it will probably be some time yet before unemployment declines consistently. Governor Glenn Stevens has again attempted to talk his currency down from lofty heights — he reiterated that the AUD is high by historical standards, particularly given the declines in commodity prices. After Stevens’s talk, the currency managed to back off quickly from AUD$0.9350. Nevertheless, with the lack of global yield, the carry trade continues to favor the AUD on pullbacks.

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