EUR/USD: One for the Textbooks

EUR, USD, One,Textbooks, ECB, Governing Council, Fundamental Analysis, fx trader, forex

04 May 2016

In the ECB statement of 21 April, the Governing Council decided, as expected, to continue with the expanded policy announced at the previous meeting1: “... it is essential to preserve an appropriate degree of monetary accommodation as long as needed in order to underpin the momentum of the euro area’s economic recovery and in order to accelerate the return of inflation to levels below, but close to, 2%...”  Hence, the ECB has clearly signaled that it will keep in force the very accommodative policy actions as well as those non-standard policy measures, at least until March of 2017.

There were some key points in the economic analysis. Q4 GDP was positive, measuring 0.3% growth, “...supported by domestic demand, while being dampened by relatively weak export trends...” Mr. Draghi also expressed satisfaction in the improvement in EU employment as well as domestic consumption, due in part to ongoing low energy prices: “...continued employment gains resulting from past structural reforms and the still relatively low price of oil should provide ongoing support for households’ real disposable income and private consumption...

Another important point covered in the analysis was the Governing Council’s concern over “... the insufficient pace of implementation of structural reforms and subdued growth prospects in emerging markets...” 

Taking everything into consideration, the Governing Council had concluded “...The risks to the euro area growth outlook still remain tilted to the downside... ...uncertainties persist... ...to developments in the global economy and to geopolitical risks...”

To be sure, there are no shortages of geoeconomic - geopolitical risks. Although the recent agreement with Turkey has stemmed the flow of refugees, the civil war still rages on. Also, in a pique of frustration with a legislative bill under discussion in the US Congress which would allow victims of the 9/11 attack to sue2, Saudi Arabia threatened to sell a significant portion of its $700 billion of US Treasury holdings. Although no longer in the headlines, the underlying causes of the Ukrainian civil conflict have not been resolved. The North Koreans have been rattling a nuclear saber and Brazil is in chaos over President Rousseff impeachment trial creating uncertainty over Brazil’s capacity to service its sovereign debt3. Last, but by no means least is the pending UK-EU referendum. This was addressed by President Draghi in the follow up press conference: “...We do expect a continuation of market volatility, certainly until the referendum... ...Is it enough to endanger the economic recovery in the euro area? The assessment of our staff is that the risk of this happening is limited...

Across the Atlantic, the US Federal Reserve seems to be taking it all in stride. The US Federal Reserve Bank’s 27 April Federal Open Market Committee statement4 stated several point which paralleled the ECB Governing Council statement above. In particular the FOMC noted in the opening sentence that “... that labor market conditions have improved further even as growth in economic activity appears to have slowed...”  Indeed, the unemployment rate in the US is half that of the EU, although there has been a debate over the quality of new jobs. Also, many individual US states have recently adopted the Federal Government’s benchmark minimum wage of USD $15.00 per hour, which may affect percentage based statistics on wage growth.

The statement also noted somewhat similar to the ECB statement that “... household spending has moderated, although households' real income has risen at a solid rate and consumer sentiment remains high... ...Since the beginning of the year... ...net exports have been soft...”  Hence, both central banks observed a contraction in exports. The Fed noted as the ECB did, that “... Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and falling prices of non-energy imports...”  This decline in exports may reflect the readjustment in China’s once insatiable import market. Lastly, the Fed has not significantly altered its wording on geoeconomic concerns: “... The Committee continues to closely monitor inflation indicators and global economic and financial developments...”

It’s worth noting one peculiar metric the Fed uses to gauge inflation risk called inflation compensation. In 1997, the US Treasury began to issue Treasury Inflation Protected Security (TIPS)6. The principal on a TIP is adjusted according to CPI. In a nutshell, the market price for unindexed Treasuries when compared to the TIPS gives an indication of market inflation expectations5. The FOMC statement has been making careful note of inflation compensation for quite some time: “... Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months...”

Hence, both the ECB and the US Fed, although experiencing economic recovery to different degrees have noted, if not equal, then paralleling concerns as well as achievements of policy.

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