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ECB’s euro problem comes into focus today

On an action packed day for financial markets yesterday the Bank of Canada raised interest rates for the second meeting in succession, the vice chairman of the Federal Reserve, Stanley Fischer unexpectedly handed in his resignation, and it was reported that President Trump would support a proposal by the Democrats to extend the debt ceiling deadline by three months in combination with an aid package for the damage that has been caused by Hurricane Harvey.

This helped US stocks, as well as the US dollar finish the day higher, despite Republican house speaker Paul Ryan declaring the proposal unworkable and ridiculous, which might render passing the proposal problematic given that Republicans control both houses.,

In any case the proposal seems eminently sensible, as well as being smart politics by the Democrats, even more so given the current circumstances with the prospect of Hurricane Irma to come, and another, Jose forming in the Atlantic.

It wouldn’t look particularly good for any Republican, whatever their views on the debt ceiling to be seen to play politics at a time of a potential national emergency, particularly with the mid-terms next year, which suggests that this particular disagreement will be overcome. Then again, as we are finding out here in the UK, politicians don’t always do what is best for the country, and would rather look to score cheap political points.

Nonetheless the rebound in US markets looks set to see markets in Europe open higher this morning with the centre piece of the day the latest meeting of the European Central Bank, as concerns about North Korea take a welcome back seat.

For several months now there has been rising speculation that the European Central Bank would look to start to prepare the ground in the coming months for a gradual tapering of monetary stimulus in the face of an improving economic outlook for the euro area.

At the beginning of the year, and even in the middle of the second quarter this didn’t look as if it would be too much of a problem, however the gradual unwind in the Trump reflation trade and decline in the US dollar has made the ECB’s exit strategy much more problematic than it would have liked.

A rising currency, and a US dollar that continues to look vulnerable has seen the euro hit its highest level since 2014, not only against the greenback, but the Chinese yuan as well, thus making EU exports more expensive in two of its biggest export markets.

Since the beginning of the year the euro has risen 13% against the greenback, with 8% of that coming in the last 3 months, and this has prompted concern that the ECB will find it increasingly difficult to hit its inflation target, if the currency continues to rise.

This is because while a 13% move may not seem all that large on an eighteen month to two year basis it’s quite a big move on a shorter term basis, after all we only need to look back at the hysteria that accompanied last year’s sharp move lower in the value of the pound in the wake of the Brexit vote, which contrasted to a much bigger move lower in the euro in 2014 when the single currency lost 25% of its value, peak to trough in the space of ten months.

A rapidly rising currency will push down on inflation, but it also has a negative effect when it comes to exports, making them more expensive. While that isn’t necessarily as big a problem on a long term basis as companies can hedge to some extent, on a short term basis it could translate into reduced profits when exchanged back into local currency, and could also weigh on economic growth expectations.

At its previous meeting the ECB forecasts estimated growth in 2018 of 1.8%, however these numbers were predicated on a euro exchange rate of $1.09. We are well above that level now with the risk we could go a lot higher, particularly since it seems unlikely that we’ll see another Federal Reserve rate rise this year, if this week’s comments from Fed governor Lael Brainard are any sort of guide to concerns on the FOMC about the inflation outlook in the US.

These concerns about the rise in the euro may help explain those reports at the end of last week that suggested a full taper plan may not be ready until December, which prompted the euro to slip back from the 1.2000 area in the wake of the weak US jobs report.

It also suggests that some ECB officials are becoming concerned about easing back too aggressively from the asset purchase program as fears grow that a euro that moves through the 1.2000 level into year-end could tighten monetary conditions too quickly. In this context ECB forecasts for both inflation and GDP are expected to be closely monitored in light of recent moves in the exchange rate.

As such while the decision is expected to be a non-event much will depend on the tone of ECB President Mario Draghi’s press conference as he tries to balance out the competing arguments from the more hawkish members of the governing council who want an interest rate rise sooner rather than later, and those who are concerned a premature tightening could prompt a slowdown in some of the weaker countries of the euro area, where unemployment levels still remain unacceptably high.

It is this more than anything that highlights the dilemma for policymakers in trying to set a monetary policy for an economy that has full employment in Germany, with Italy and Spain who remain a long way short of it.

One thing is certain Mr Draghi will have to use every ounce of his verbal dexterity in keeping expectations managed on both sides of the monetary policy divide.

EURUSD – the risk of a short term peak remains while below the 1.2000 level. A break below the 1.1820 level argues for a move towards the 1.1600 area. Above 1.2000 retargets the 1.2070 peaks.

GBPUSD – has pushed up to the 1.3080 area brining us closer to the 1.3140 area as well as the August peaks at 1.3268. Support now comes in at the 1.2980 area and below that at the 1.2850 area.

EURGBP – pressure remains on the downside while below the 0.9220 area with the risk of a move towards the 0.9040 area. It would take a move back through the 0.9230 area to stabilise and retarget the 0.9300 area.

USDJPY – support still remains down near the 108.20 area for now and the August and April lows and this is currently containing the downside. Rebounds need to get back above the 111.00 area, otherwise we remain at risk of a move towards the 106.80 area.

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