ECB President Mario Draghi gave a masterclass in how not to talk down the euro. It was not so much that he did not try, but financial markets sensed that he did not have sufficient conviction. Indeed, the euro strengthened significantly during the press conference, as expectations of interest rate hikes built further and bond markets sold off. Most explicitly, the opening statement warned that ‘the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability’. This was especially the case given that ‘domestic price pressures remain muted overall and have yet to show convincing signs of a sustained upward trend’. However, the warning was not convincing enough and he seemed to undermine the point by saying that part of the euro’s strength was justified by the improving economic outlook. Indeed, Mr Draghi sounded increasingly positive about the economy and his comments signal further upgrades in the ECB’s economic growth forecasts. Later in the press conference, the ECB President made a more explicit effort to push back rate hike expectations and the euro, stating clearly that he saw ‘very few chances at all of a rate increase this year’. That had some impact on financial markets, but was not sufficient to offset earlier moves.180125-Global-Daily.pdf (43 KB)
Meanwhile, Mr Draghi expressed concern about recent comments by the US administration, which seemed to encourage dollar weakness, though here too, he was relatively cautious. He referred to international commitments to avoid competitive devaluations, but did not go much further than that.
Following the ECB meeting, financial markets continued to price in a relatively aggressive path for interest rate hikes. Eonia forwards are consistent with a 50% chance of a 10bp rate hike by the end of this year, and are pricing in more than one full rate hike by March of next year. We think that the ECB will be slower in withdrawing policy accommodation given the subdued outlook for core inflation. In particular, although the ECB will unlikely extend QE further, a tapering period may well follow beyond September 2018. In addition, we do not expect rate hikes until the second half of next year (we have pencilled in a first move in September 2019). If we are right, a re-pricing of market rate hike expectations should be a headwind for both euro government bond yields and the euro.
Nick Kounis, Kim Liu, Aline Schuiling and Georgette Boele