Euro Exchange Rates Boosted as ECB Minutes Show no Imminent Action Likely

The euro's positive run against the British pound continues as the European Central Bank confirms it is happy with recent economic developments in the Eurozone.

The pound to euro exchange rate site precariously above support at 1.32 on global exchange rate markets. Downside pressure remains intact with momentum advocating for further declines.

A combination of factors are at play here. Importantly euro buyers feel there is a fundamental justification to pick up euros at these levels as there is a growing sense of confidence in the Eurozone economy as recent data releases provided confirmation of the ongoing cyclical recovery in the euro area.

Real GDP had continued to grow in the third quarter, while other incoming information, including the latest survey evidence available up to November 2015, remained consistent with a continued moderate economic recovery.

And most importantly the governing members at the European Central Bank believe the policy measures they have put in place are working:

“The recovery, although modest but still with growth rates above potential, remained intact,” read the account of the last meeting held by the Governing Council at the ECB which markets have read as a suggestion that no euro-negative actions will be taken for some time yet.

The minutes of the ECB’s last policy meeting does however show governing members remain concerned about the large amount of slack that was estimated to remain in the euro area economy.

The December 2015 Eurosystem staff projections pointed to the output gap not being fully closed over the projection horizon.

They also indicated that the rate of unemployment would not fall below 10% even by the end of the projection horizon in 2017. Moreover, it was noted that – in contrast to consumption – investment remained very weak and had again disappointed recently, with the December projections showing a downward revision.

Therefore the risk remains for more potentially euro-negative policy decisions to be made at the ECB over coming weeks. This should keep euro strength capped.

A Potential Negative for the Euro: Quantitative Easing is Open-Ended

Be wary of the ECB though, they will not like the currency to strengthen in 2016 as they need it to keep Eurozone exports competitive.

As such, there were notes in the latest ECB communication that suggested action in 2016 is possible:

“When extending the programme, it was viewed as important to retain both the calendar-based and contingency-based elements of forward guidance, which included not only extending the intended end date to March 2017 but also reaffirming that the Governing Council would continue to add monetary accommodation via continued purchases for as long as needed to achieve a sustained adjustment in inflation.”

The ECB also discussed various ways in which their 60bn a month QE programme might be expanded to heighten its impact:

“The possibility was also raised of expanding the monthly volume of purchases or, alternatively, of frontloading purchases within the envisaged envelope so as to strengthen the impact in the short term.

“Moreover, the option was raised of extending the horizon beyond the suggested six months, so as to increase the overall volume of purchases above the level suggested by Mr Praet.

“However, there was broad agreement that such measures would not be warranted at this juncture, while a reassessment could be made in future.”

Nevertheless, although the minutes were characterized as dovish by most market commentators the report cited many governing council members who were against the extension of QE as they saw long term risks: 

“In particular, purchases of sovereign debt, while considered to be a legitimate monetary policy tool, were seen to be associated with significant risks and side effects, and should therefore be kept in reserve as a contingency measure in case of extremely adverse developments, such as deflation, and should not be used as a means to fine-tune the inflation outlook.”

It should also be noted that there was considerable opposition to the measures put forward at the December meeting:

“Some members did not, on balance, see a sufficient case for further policy action or were only prepared to support some of the elements put forward.

“Among the latter, a few members expressed a preference, if further accommodation was seen as warranted, for limiting policy action at the current meeting to a cut in the deposit facility rate.”

In regards to the inclusion of muni bonds in the ECB’s programme, the issue of the limited supply of sovereign bonds for the ECB was raised – which has been a concern touched on by analysts as self-limiting the size of the programme:

“It was felt that this measure would contribute to avoiding any possible strains on the availability of securities, especially in view of the extension of the programme beyond September 2016.”

Inflation Outlook

As far as inflation went, whilst the ECB downgraded its projections, it should be noted there were those who saw upside potential:

“Some positive signs could also be observed with respect to the risk of deflation and the anchoring of inflation expectations.

“The argument was advanced that, as the cyclical recovery proceeded, the likelihood of extreme developments, such as outright deflation, diminished.

“This was supported by survey-based evidence on the distribution of inflation expectations.

“It was also remarked that, while market-based expectations for inflation were below the ECB’s inflation aim, this need not signal an unanchoring of expectations.”

In light of the above analysis the dovish spin put on the minutes could be a temporary market view which will only influence the exchange rate in the very short-term.

BOE Minutes Compared

The recovery in sterling against the euro, was based on a divergence in the monetary policy outlook. 

This was brought into sharper contrast due to the BOE also releasing its minutes for the January meeting on the same day as the ECB.

The policy decision from the meeting was to keep the bank rate at 0.5% and asset purchases at 375bn.

The minutes showed no change in the voting, which remained at 8-1 for keeping policy unchanged, which Ian McCaferty the only dissenter.

Whilst the minutes showed little change from November in terms of their outlook for inflation and no real change of stance by the MPC - if anything economic activity was seen to have slowed since November:

“business surveys imply that the near-term outlook for aggregate activity is slightly weaker than in the MPC’s November central projection.

“Productivity growth appears to have recovered somewhat over 2015, but the underlying supply capacity of the economy, and therefore the degree of inflationary pressure resulting from a given pace of demand growth, remain difficult to judge.

“pay growth remains restrained and appears to have dipped slightly in the most recent data."

Nevertheless the MPC continued to expect 'cost growth' "to increase over time."

“while domestic cost growth over the past year has been below that necessary for inflation to return sustainably to the 2% target, its pace can be expected to increase over time.”

There was a further dovish admission that when rates rose they would so gradually.

Importantly members were unanimous in their agreement of this point:

“All members agreed that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so only gradually and to a level lower than in recent cycles. This guidance is an expectation, not a promise.”

Levels to Watch 

Although GBP/EUR rose strongly to nearly 1.33 following the release of both minutes, it kept below significant support at 1.3367 from previous lows, and is the level of a neckline for a large bearish consolidation pattern or Head and Shoulders on the charts (see  chart below).

Previously the pair had broken clearly below the neckline and the monthly pivot and was on its way lower to 1.3000, and then possibly even 1.2664 eventually, however, today’s events reversed the bearish bias short-term.

A two bar reversal on the 4-hr chart, which also happens to be a bullish engulfing indicates short-term strength at least – if not a potential reversal.

However, evidence is insufficient to indicate a longer-term reversal of the current bear trend.

The charts are still showing a break below the neckline of the H&S, with bearish consequences, however, the down-trend has stalled.

A break back above 1.3367 would temporarily cancel the bearish outlook and 1.3000 target.

In the absence of such a break, however, I remain bearish the pair and loyal to the 1.3000 initial target.

In addition, as shown above I do not think that the ECB and BOE minutes showed a sufficiently divergent outlook to be the source of a reversal, nor in my opinion, was the ECB document as dovish as first characterised by commentators.