Euro Dominates Pound Sterling and Dollar as ECB Signals a New Path Forward

- Euro outperforms its peers
- ECB reveals its new strategy
- ECB's message at odds with market expectations
- Move could yet be a knee-jerk reaction

Above: ECB President Christine Lagarde. Image: Andreas Reeg/ECB.

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The Euro has attracted some strong buying interest ahead of the weekend and has pushed the British Pound decidedly lower, a development that could signal an end to the Pound's near-term advance against the Eurozone's single currency.

The Euro advanced after the European Central Bank (ECB) said it would now be more tolerant of inflation levels above 2.0% in the future following the conclusion of an 18-month strategy view.

The market reacted by buying the Euro in a sign that they were expecting the ECB to be more aggressive in their pursuit of higher inflation, although some analysts are saying nothing has really changed at the ECB which could in turn suggest the FX market is guilty of a knee-jerk reaction.

Before delving into the details of what was said, the rule of thumb is as such: when a currency moves following an event it usually suggests the outcome of that event was unexpected.

In this instance the ECB's policy review was to some degree initially at odds with market expectations.

The ECB review nevertheless combined with a broader sell-off in global markets which only added downside pressure on the Pound-Euro rate, ensuring it suffered its largest fall since April 06:

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ECB President Christine Lagarde announced the ECB will tolerate inflation levels above 2.0%.

This makes a departure from the "close to, but below" 2% guide that is currently the case and suggests it will pursue a policy of low interest rates for a significant period of time.

"A transitory period in which inflation is moderately above target," was the key statement from the ECB which the market has latched onto, this marks a departure from the previous aim of getting inflation "below, but close to, 2%".

According to Bipan Rai, North America Head, FX Strategy at CIBC Capital Markets, the new target is basically how the Bank of England and Bank of Canada already conduct policy.

The rally in the value of the Euro is something of a surprise given the ECB has effectively signalled it will tolerate higher inflation and therefore will keep interest rates 'lower for longer' in order to guarantee Eurozone economic growth.

When it comes to central banks and their currencies, 'lower for longer' is typically associated with currency underperformance.

But Rai explains that what the ECB announced might in fact not be as bearish for Euro exchange rates as the market appears to have been expecting heading into the review.

"This is still bearish EUR over the medium-term, but not as bearish as a flexible average inflation target might have been," says Bipan Rai, North America Head, FX Strategy at CIBC Capital Markets.

And here lies the surprise: the outcome of the review was expected to be more bearish for the Euro than what ultimately transpired.

Rai explains "the big difference between the ECB’s new approach and FAIT is that the latter intends to overshoot to make-up for prior misses. The new ECB approach will tolerate an overshoot."

[Explainer: Flexible Average Inflation Targeting (FAIT) is the new framework adopted by the U.S. Federal Reserve and allows for higher levels of inflation if required to push employment levels up to what are deemed acceptable levels.]

Aila Mihr, Senior Euro Area Analyst at Danske Bank, agrees:

"This implies a more flexible and less aggressive inflation targeting regime than the Fed's average inflation targeting , which explicitly requires making up for any past inflation misses. In that sense, the new symmetric ECB target is somewhat less aggressive than the Fed's AIT".

The intention to overshoot the 2.0% inflation target therefore comes across as being more aggressively accommodative than an intention to merely tolerate an overshoot inflation, which the ECB is aiming to achieve.

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A number of analysts who have assessed the ECB's review do however conclude that very little has in fact changed, which could mean the Euro's rally is a knee-jerk one that might ultimately be reversed.

Although the review was 18 years in the making, Holger Schmieding, Economist at Berenberg Bank says the new framework is largely in line with expectations, but with a dovish tilt.

"The more modern and clearer strategy will make it easier for the ECB to communicate with markets and the public. It enshrines the flexibility which the ECB had granted itself anyway. The result does not change our outlook for the future course of monetary policy," says Schmieding.

Key to the outlook for Euro exchange rates will be to what extent the broader market agrees with this assessment.

If the market reaches the conclusion that ECB policy is in fact largely unchanged then the recent move higher in the Euro could presumably be reversed.

In fact Schmieding has come away with a completely different interpretation to that pro-Euro interpretation from Rai and Mihr (as discussed above).

He says "this explicit reference to a temporary overshoot is not Fed-style inflation averaging. The ECB does not seem to be aiming explicitly at such an overshoot. But the ECB is signalling an even stronger tolerance of a temporary overshoot than we had expected."

Above: Total assets held on ECB’s balance sheet and assets held for monetary policy purposes (green).

Lagarde said the ECB Council approved the new strategy unanimously.

"Even the proverbial hawks thus approved it in the end. It re-arranges the stage for future policy debates in the ECB Council without changing the likely outcome of such debates, in our view," says Schmieding.

Danske Bank do not expect this new "symmetric inflation target formulation" to have much implication for monetary policy in the short- to medium-term.

"Despite an accelerating recovery and growing cost-push pressures in manufacturing, the outlook for underlying inflation is still muted in the euro area and we remain sceptical that core inflation is about to return to the highs preceding the Global Financial Crisis on a sustained basis," says Mihr.

The Euro rallied ahead of the official announcement as it had been leaked to the press, with gains accelerating once the details were confirmed in the official statement and press appearance by Lagarde.

The Euro-to-Pound exchange rate rose by over three-quarters of a percent at one stage to quote a high of 0.8614, giving a Pound-to-Euro exchange rate low of 1.1600.

The Euro-to-Dollar exchange rate at one point rose by over half a percent to reach a high of 1.1864.