For currency traders, talk is cheap, even when the person speaking is the president of the European Central Bank.
Mario Draghi’s suggestion this weekend that the ECB may ease policy to address the euro’s advance marked a strengthening of a position he’s been setting out for weeks. Yet the 18-nation currency has shrugged off his repeated comments and climbed since the beginning of March, while options traders are about the least bearish on the euro since November 2009.
The challenge for Draghi is capping euro gains that have slowed inflation to a quarter of the ECB’s 2 percent target and which run the risk of the sluggish growth that blighted Japan in the 1990s. Traders are trying to judge whether the central bank head is willing to back his words with sufficient firepower to end a 20-month rally in the shared currency.
“The ECB will probably continue with these types of comments, but talk is cheap,” Athanasios Vamvakidis, the head of Group-of-10 foreign-exchange strategy at Bank of America Corp. in London, said yesterday in a phone interview. “The market will need to see action for the euro to weaken substantially.”
Vamvakidis said he expected the euro to weaken below $1.35 in the “next few months,” driven by improvements in the U.S. economy that will enable the Federal Reserve to keep cutting its quantitative-easing program. The median estimate in a Bloomberg strategist survey is for a decline to $1.36 by June 30 and $1.30 by year-end, from $1.3825 as of 10:30 a.m. in New York.
Draghi told reporters at the International Monetary Fund meeting in Washington on April 12 that “the strengthening of the exchange rate requires further monetary stimulus.”
While the euro tumbled 0.5 percent in London trading yesterday, that was only its biggest drop since March 19. The 18-nation currency weakened another 0.2 percent today, leaving it 0.4 percent higher since the start of the year.
“Just about everything is being considered, but in all likelihood, absent a crisis, very little will be deployed,” Bert Lourenco, the head of EMEA rates research at HSBC Holdings Plc in London, wrote today in a report. “Flows should support the currency as this is a sign of confidence and progress in the euro-zone re-balancing.”
Investor appetite for assets such as Greece’s oversubscribed, 3 billion-euro ($4.1 billion) bond sale that last week ended the nation’s four-year exile from international debt markets are buoying the currency.
Those gains are capping increases in consumer prices. An official report tomorrow will confirm that annual inflation slowed to 0.5 percent in March, from 0.7 percent the month before, according to economists surveyed by Bloomberg. That would be the lowest reading since November 2009. Price gains haven’t matched the ECB’s 2 percent target since January 2013.
“Further weakness” in the euro “from hereon will depend on inflation data,” Kiran Kowshik, a strategist at BNP Paribas SA in London, wrote in a client note yesterday. “ECB governing council members have made clear that the central bank is very much prepared to ease further, but wants to see how inflation data plays out in the next couple of months before deciding.”
ECB Governing Council member Christian Noyer warned last month that a stronger euro creates unwarranted pressure in the economy, and told CNBC yesterday that policy makers “stand ready to act” on stimulus.
Ewald Nowotny, who also sits on the governing council, last week identified June as a potential trigger point for easing policy further and said officials will discuss whether to embark on a bond-buying program. Draghi said March 13 that the exchange rate is “increasingly relevant in our assessment of price stability,” and estimated March 6 that the euro’s strength had cut 0.4 percentage point off inflation.
The problem is that traders have misinterpreted their comments, according to Ulrich Leuchtmann, the head of currency strategy at Commerzbank AG in Frankfurt. He said markets have for weeks failed to realize how willing Draghi is to extend stimulus, forcing him to toughen his rhetoric this weekend.
“I’m not convinced that the market really has learnt much,” Leuchtmann wrote yesterday in a client note. “The effect on euro-dollar is much too limited. It’s still not reflected in the market prices that market participants have really understood Draghi, or that they believe him.”
Commerzbank predicts the euro will remain little changed at $1.38 mid-year, before sliding to $1.34 in December.
Options traders have this year reduced bets that the euro will weaken. The premium on one-year puts to sell the currency over calls allowing for purchases narrowed to a 4 1/2-year low of 0.91 percentage point on April 11, data compiled by Bloomberg show. That’s down from a high for the year of 1.39 on Jan. 2. Since Draghi’s announcement, the premium has widened to 1 percentage point, the largest increase since October.
The ECB could reduce its refinancing rate from 0.25 percent or implement a negative deposit rate, stop mopping up the excess liquidity from its asset-purchase program or follow the Fed in printing money.
Bond purchases may end up supporting the common currency further by attracting more foreign cash to euro-denominated securities, according to Jane Foley, a senior currency strategist at Rabobank International in London. Her firm sees the euro falling to $1.36 by mid-year and $1.30 by Dec. 31.
“It’s a battle that’s difficult to win, and the ECB is at the mercy of other central banks such as the Fed to weaken its currency,” Foley in a phone interview yesterday. “One thing about jawboning is that it begins to lose its effect if the central bank doesn’t follow through with action.”