EURO: Greater Vulnerability of the Single Currency

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The ECB meeting of 20 October did not bring particular changes compared to the previous meeting on 8 September. Monetary policy parameters remained unchanged, as also the macro scenario: growth continues at a moderate but steady pace, and headline inflation is rising gradually, although in part due to a favourable base effect and with core inflation showing no sign of a convincing upward trend. Risks to the scenario remain skewed to the downside in any case, and monetary policy must stay markedly accommodative.

The central topic of the meeting should have been the possibility of extending QE to beyond March 2017, but the ECB made no commitment. Not only: Draghi said that the option had not even been discussed during the meeting, and added that the current extraordinarily expansive conditions cannot be maintained “forever”. On these indications, the euro, which in the past few days had dropped as far as EUR/USD 1.09, rebounded and returned to above the crucial threshold of EUR/USD 1.1000.

Shortly thereafter, however, during the Q&A session, Draghi said that during the meeting no tapering of purchases was discussed, either. And on this statement the euro dropped back to below EUR/USD 1.1000. The decline continued as far as the EUR/USD 1.08 area (low of 1.0859) – a level which coincides with our downside target.

Now that the goal has been reached, where will the euro go? Can we maintain our outlook for the exchange rate or should we revise it down? We are inclined to confirm it, while indicating that downside risks have increased. The fact that the euro has declined even if the indications provided by this month’s meeting were not more dovish compared to the September meeting, may be interpreted as signalling a greater vulnerability of the single currency, in a situation in which the euro area scenario is still uncertain, and the ECB – at like for like scenarios – is split internally on how to proceed.

In any case, two main aspects should be given thought: the origin of the euro’s decline, and the ECB’s behaviour in December.

1. The origin of the euro’s decline

The decline originated before the ECB meeting, at the beginning of October, on the consolidation of expectations for a fed funds rate hike before the end of the year. This reminds us that the impact on the exchange rate of the Fed’s behaviour should not be overlooked. The prospect of a Fed hike by the end of December strips the euro of support, but only limitedly so, both because the Fed is likelier to make its move in December rather than November (the FOMC meeting of 2 November will come only a few days before the Presidential elections in the US, on 8 November) and because the Fed has indicated its intention to proceed at an extremely gradual pace in hiking rates subsequently, prospecting only a couple of moves next year.

Therefore, the decline of the euro was triggered by the Fed, and the ECB “only” amplified the movement, although it may not immediately be apparent how. Had the ECB showed openness to extending the QE programme to beyond March 2017, the correction of the exchange rate would have been compatible and easy to explain. However, in addition to not leaving the door open for an extension of QE, the ECB went as far as “admitting” that the option had not even been discussed.