The euro was poleaxed on Thursday, tumbling by 1.37% against the US dollar, its largest one-day percentage loss since the UK Brexit referendum last year.
A masterclass from European Central Bank (ECB) President Mario Draghi in central bank speak — turning what was ultimately a reduction in the size of the bank’s quantitative easing program into something that was perceived as dovish — did the bulk of the damage, sending the EUR/USD skidding to a three-month low.
And its losses are continuing today in Asia.
Brian Martin, Head of Global Economics at ANZ, says the key behind the euro’s plunge was that Draghi refused to rule out extending or increasing the size of its quantitative easing program beyond September next year.
“Importantly for FX markets, the ECB indicated that it stands prepared to increase QE if financial conditions deteriorate and threaten the anticipated, gradual recovery in inflation,” he says.
“The exchange rate is a significant part of that.
“We know from the September ECB meeting that the governing council is concerned about the disinflationary implications of a sustained appreciation in the exchange rate.”
Given Draghi’s early success in helping to avoid those risks, the question that many are now asking is whether the euro’s move lower will continue.
To Martin, the risks are that it will, pointing out several factors that may work against the euro in the period ahead.
These include the near-term path of US inflation, which is expected to gradually recovery towards 2% as transitory factors that have held inflation down in recent months unwind (ie price drops for mobile phone services, prescription drugs). That is in contrast to the anticipated near-term path of euro area headline inflation, which is expected to dip sharply to 0.9% year-on-year in Q1 next year as base effects drop out of the index. The appointment of a new chair at the Fed may also reinforce the outlook for higher US policy rates. Meanwhile, the future German government’s anticipated lack of appetite for deeper EU integration and the Catalonian situation have dampened some of the positive political tailwinds that were supporting the euro during the summer.
Along with those potential headwinds, Martins says there are also plenty of positive signs emerging that may act to support the US dollar.
The prospect of tax cuts are also re-emerging in the US. One additional development that has the potential to positively affect the dollar is the unfolding recovery in US business fixed investment. As investment recovers, demand for capital is likely to rise. In an environment of gradual interest rate rises and balance sheet normalisation, that could contribute to modest upward pressure on bond yields.
Another positive influence on the US capex cycle is that the US is at or close to full employment. Skilled labour shortages are evident in the JOLTS survey and in the rise in NFIB’s reported jobs that are “hard to fill”. That labour constraint is supportive of firmer capital spending. A sustained pick-up in business fixed investment should underpin higher productivity growth and, in turn, firmer wage growth.
Martin says points to some potential downside risks to EUR/USD in the near-term.
Current market positioning among speculators who are long the euro but short the US dollar could also pose downside risks, with further losses in the EUR/USD increasing the probability of position squaring or switching from traders.
The EUR/USD currently trades at 1.1628.
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