At this week ECB rate decision, we believe the governing council will signal the end of asset purchases. However, the language will be used to limit the markets impact and limited further speculation about interest rate hikes.
The challenge for the ECB will to keep policy flexible without triggering a stampede into the single currency. Currently, over half of the council members have delivered hawkish statements. The general view remains that should inflation positive trend remain stable, bond buying should be taper. Core inflation has continued to float around the 1% mark. Yet, negotiated wages has just accelerated from 1.6% to 1.9% indicating prospect of wage inflation.
The hawkish majority received substantial boost when ECB chief economist Praet indicated data supported the end of net purchases. Praet view carries influence, since the chief economist will provide economic recommendations to the governing council. In our view, the failure of euro rally further is due to the focus on the 'pure' economic data rather than 'big' picture. The cyclical economic weakness and systemic political threats have captured short-term volatility trader’s attention. However, we suspect the primary driver for the ECB decision to remove extreme policy is practical over fundamental.
Firstly, the massive QE program has expanded the ECB balance sheet to destabilising heights. Given the size of the ECB balance sheet, the issue of 'moral hazard' has been reintroduced. To the concern of ECB, Italian politicians dragged the banks strategy into the national debate. The ECB wants to avoid owning more then 1/3 of a nation’s sovereign debt, which after years of purchase the central bank, is coming dangerously close. Secondly, highlighted by the spike in Italian yields and broader fears of crisis, the ECB needs to reclaim their primary tools. With a bloated balance sheet and negative rates, the ECB has few policy options to defend the European Union.
As with the Fed in 2013, 'normalisation' was not just a function of economic data but also an external consideration. It’s critical to understand that ending QE does not necessary mean higher policy interest rates. We remain constructive on EURUSD as US rate hiking cycle is slowly ending while ECB is nearing the start position. We see the current level of 1.1750 as a good position to reload strategic longs.
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