EUR Longs Have Few Places to Hide

Investors are only interested in one number this morning and that’s the Euro flash consumer-price index (CPI). Would it fall into negative territory for the first time in five years? And if so, would it bolster market expectations of a more aggressive policy response from the European Central Bank (ECB)? It has and not necessarily so.

As expected, consumer prices fell on an annual basis in December for the first time since the depth of the financial crisis. The headline print came in weaker than forecasted with a reading of -0.2%, year-over-year, compared to expectations for -0.1% and +0.3% in November. The core rate has actually moved higher to +0.8%, year-over-year, compared to +0.7% previously. The results will complicate things a little, but the headline rate is likely to be used to justify ECB initiating quantitative easing (QE) even if much of the decline seems to be attributed to volatile factors.

Sustainable lower prices tend to have a far-reaching negative impact on an economy. Eventually, it will only compound the eurozone’s problems of weak output growth, high unemployment, and falling business investment. Falling consumer prices make it tough for households, governments, and corporations to repay their debts, which currently sit at record highs. Falling prices may pressure consumers and businesses to postpone future consumption and investment. The spiraling and knock-on effect could raise unemployment, stunt any economic growth, and push prices even lower.

ECB: What Now?

The market now looks to the ECB for a response. All along, President Mario Draghi and company have indicated that they will respond to the latest weakening in the inflation outlook with fresh stimulus measures that could include purchases of sovereign government bonds. In the spirit of transparency, the central bank chief said last month that the ECB is making “technical preparations” to alter the size, pace, and composition of its stimulus program.

A percentage of the market will interpret this morning’s data that it’s no longer “if” the ECB will announce QE on January 22, but “how” will it be tailored despite the rate of inflation being driven by a sharp fall in energy prices. Energy prices fell -6.3% last year, while prices of other goods and services were still +0.6% higher than a year earlier, but well below the ECB’s desired inflation target of +2%.

The ECB has a number of tough questions to ask and answer before acting. If energy is the culprit, should the ECB rush to provide further stimulus? Lower energy prices could boost consumer discretionary income and eventually consumption. Are a couple of months of negative pricing a serious trend that defines deflation? Not necessarily so. One needs to throw in declines in gross domestic product and wages before it can be said deflation is taking a firm grip.

The Market Interprets an ECB Plan

The market is reporting that the ECB is eyeing three possible outcomes for QE including purchasing bonds on capital keys, buying only AAA-rated paper including loans, and allowing member state’s central banks to buy their own bonds based on capital keys.

Ideally, the easier solution for the ECB would to end austerity rather than implementing a modified form of QE. Draghi and company require a fiscal policy to work better with monetary policy to promote investment and growth but that won’t happen with such an eclectic bunch of economies.

A Diverging Job Market

This morning’s eurozone job data shows the divergence of economies within the region. German unemployment at +6.5% in December is at a record low while Italian unemployment at +13.4% is at a record high. A small plus for the ECB is that unemployment fell sharply in Germany for December (-27k), which would suggest that consumer spending should support activity in Europe’s largest economy. For investors, it seems that Italy, and other periphery economies will have to wait for the ECB and its next phase of monetary stimulus before the market can see a change to growth, investment, and inflation for the less robust economies. The event risk for the ECB’s January 22 meeting is whether Draghi will stand and deliver what the market expects.

Long-EUR Positions Face Challenges

This morning’s CPI has the 19-member single currency on the move again, albeit at a snail’s pace inching to a nine-year low (€1.1845). The single unit has lost 1.9% year-to-date (less than a week), even hitting many third and fourth quarter forecasts. Being short EURs is a profitable, crowded trade and also somewhat tired. Most of the positions have been piled into since the holidays ended. Investors and dealers do expect more downside movement over the coming weeks as investors continue to price in sovereign QE, a Greek exit from the eurozone, and Russian-related risks. Uptick moves thus far have been very limited. Current future EUR shorts are still -15% below last year’s peak and -30% below the 2012 record. Now that the market has broken through €1.1860 after the CPI print it should open the way for the January and February lows of 2006 (€1.1800 and €1.1826) to be tested.

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