FX DAILY: Any June ECB action is an alternative to QE, not a precursor to it

9th May 2014

  • The UK’s “Great Recession” should finally be declared over today, when the think-tank NIESR will forecast that UK GDP has, at last, recovered to levels last seen before the 2008 financial crisis. (The Times)
  • Japanese automaker Toyota yesterday announced a record high operating profit of Y2.29 trillion for the year ended Mar.31, marking the company’s first record profit since fiscal 2007. (The Nikkei)
  • The BoJ says its Nagoya branch manager Atsushi Miyanoya has been promoted to one of the six executive directors supporting the BoJ governor and will also serve as the bank’s Osaka branch manager in western Japan. (MNI Market News)
  • Lui Shijin, deputy head of the China’s Development Research Centre said the country’s current economic growth is in line with its potential growth rate and there is no need to be negative on China’s growth outlook. Lui said there are increasing signals that the Chinese economy is bottoming out, noting the fast growing services sector, strong labour force demand and improving external demand. (People’s Daily)
  • China’s export growth is seen improving further in coming months, according to the head of the statistics department at the General Administrations of Customs, noting the export outlook index rose to 41.9 in April from 41.7 in March. (People’s Daily)
  • The RBA’s May Policy Statement noted that GDP and CPI forecasts were little changed despite the higher AUD. Near-term GDP forecasts were higher and inflation lower. The central bank upgraded their view on household spending, housing construction and the labour market. Any major China steel production weakening was seen as a risk to GDP.
  • China April CPI was at 1.8% year-on-year versus estimates of 2.0%. This represents a sharp decline from 2.4% in March.
  • Germany’s Trade Balance came in under expectation at 16.4B in March versus estimates of 17.4B. Exports were seen down -1.8% in the month in March and imports down 0.9% on the month.

Euro-dollar rose to $1.3993 on the ECB’s initial decision to maintain interest rates, eagerly to break through the $1.40 level. However the trigger never came. Draghi managed to price more easing expectation in to the market when we thought he couldn’t tie the central bank in to anymore action. There were two net take-aways from yesterday’s press conference. The first is that the central bank has its sights on the exchange rates. The second is the June meeting is D-day. The exchange rate was mentioned a total of 11 times by Draghi, a considerable amount of lip service when the rate isn’t a policy target. Draghi gave the exchange rate as both a downside risk to inflation and also growth. A number of European corporates, including Adidas, have seen the adverse effects by a strong exchange rate on their bottom line in the recent earning season. “The strengthening of the exchange rate in the context of low inflation was cause for serious concern in the view of the Governing Council” and the Governing Council was not resigned to having too low inflation. It is clear the central bank sees the high exchange rate as responsible for aggravating the disinflationary forces of lower food and energy prices and as Draghi himself said the “Governing Council is comfortable with acting next time”.

Draghi made significant reference to the June meeting. The fact that new information on inflation, growth, bank lending as well as Eurosystem staff forecasts will be available at the June meeting was alluded two twice in the opening statement, we get the message already! Draghi even referred to today’s discussion as a “preview” for the discussion in June. The central bank is comfortable with acting against the high exchange rate but before they “want to see the staff projections that come out in June”.

So what will the policy reaction to a high exchange rate be? During yesterday’s Q&A, Draghi didn’t even rule out direct FX intervention. However Draghi’s policy of absolute transparency in monetary policy means we already know the central bank’s reaction function to a too high exchange rate. Speaking at the Dutch central bank conference on April 24th, Draghi detailed that a high exchange rate would be combated through conventional policy alone. This, he detailed, involved lowering the interest rate corridor, including negative deposit rates, a further extension to fixed-rate full allotment procedures and may even include new liquidity operations such as another LTRO. Only a slight downgrade in the inflation outlook is needed for Draghi to act in June and our baseline scenario is for a cut to the deposit rate which may alsoby accompanied by cuts to the refinancing and marginally lending rate.

This action will leave only unconventional measures left on the table in future and we would highlight that any June action is an alternative to broad-based asset purchases, not a precursor to it. Deflation is not a real threat to the eurozone and Draghi knows it. He is targeting the source, a high exchange rate as opposed to the symptom, low inflation. Draghi did highlight another evolving risk in the euro area. There should now be some signs of a pick up in credit flow after three consecutive quarters of rising growth. This, he said, “is certainly something we have our eyes on in the coming weeks,…, and the coming months”. Draghi is still waiting for the completion of the Asset Quality Review and istrying to rejuvenate the European Asset Backed Securities market for SME loans. If these don’t work, and there are real risks it won’t, we could see either a targeted LTRO or outright asset purchases of ABS loans to the private sector.