WESTPAC: The euro rally is unlikely to last

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Like a spring released from under pressure, the euro ripped higher overnight despite the European Central Bank delivering a so-called policy “bazooka” at its March monetary policy meeting.

The catalyst for the sudden and sharp recoil in the euro came from ECB president Mario Draghi during his scheduled press conference after the initial rate decision was delivered.

“In the early minutes of the press conference, the euro started to rally,” said Westpac currency strategist, Sean Callow, in his morning note. “In particular, there was short-covering as Draghi said the ECB did not anticipate any further reduction in rates.

“He also said that there were limits to how negative rates could go, mentioning bank profitability.”

And rally the euro did. Just have a look at the turnaround in the EUR/USD over the course of Draghi’s press conference, shown in the chart below. It was massive, and in all likelihood, exactly the opposite to what Draghi would have wanted.

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Eventually the euro rally topped out at 1.1218 against the US dollar, representing an increase of nearly 4% from the intra-session lows struck before Draghi started speaking.

While some put the rally down to a genuine belief that the policy measures announced by the ECB will help lift Eurozone growth and inflation expectations, Richard Franulovich, Westpac’s G10 FX macro strategist, doesn’t completely buy that notion, suggesting that while the euro could push as high as 1.13 in the days ahead, the rally is unlikely to be sustained.

Instead, as he and Callow point out in various publications released overnight, next week’s US Federal Reserve meeting could easily reverse the move, offering traders and investors the opportunity to position for renewed euro weakness in the week’s ahead.

“We struggle to get excited about meaningful EUR upside,” says Franulovich. “Next week’s FOMC could easily stymie EUR.”

Wikimedia CommonsHere’s a snippet from Franulovich’s report released overnight, explaining what he expects from next week’s FOMC meeting.

The Fed’s infamous dot plot should reveal fewer hikes, perhaps three in 2016 and 2017 vs four each year as of the last projections, but the statement should be more hawkish. Upside surprises on growth, jobs and inflation will alleviate concerns about downside risks and should see the Fed declare that the risks to jobs and activity are once again “balanced”, a characterisation they eschewed from making in their Jan statement. The statement should also signal that upcoming meetings are “live”, perhaps by using language similar to that of Oct 2015 when the Fed put markets on notice with the comment that, “In determining whether it will be appropriate to raise the target range at its next meeting”.

Franulovich believes that a hawkish shift from the Fed, indicating that rates may move higher than what the markets currently expect, “should see the USD benefit from likely further positive data surprises”.

The EUR/USD currently buys 1.1175.

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