Even as EUR firms, ECB exit from current monetary policy is high risk
The European Central Bank (ECB) is readying markets for a very gradual wind-down of its ultra-lax monetary policies, but traders shouldn’t get too optimistic as the ECB faces one of the most difficult exits of any central bank.
The EUR has enjoyed a strong bull run since December 2016 and has picked up steam in recent months as USD has lost its puff with some big investment banks calling time on the greenback’s rally. By default, continued USD weakness should push the EUR up, all things being equal.
Meanwhile, the ECB has been dropping subtle hints about the possibility of very gradually starting to reverse negative interest rates and / or its quantitative easing programme – it will be so gradual that nothing may happen for the next 12 months.
The ECB believes the Eurozone needs this lax policy for longer to ensure the recovery becomes self-propelled and also inflation is still a long way from its 2.0% target at 1.3% in June and 1.4% in May. Clearly inflation will be decisive for the ECB, but at the moment inflation pressures seem weak for the Eurozone particularly as the EUR is rising, wage increases are stagnant and commodity prices are relatively stable.
However, if the Eurozone recovery does remain sustained and inflation does tick up, the ECB will be under tremendous political pressure to rein in its monetary largess, particularly from Germany and probably the Eurozone’s trading partners, particularly the protectionist minded US.
But that exit will be far from easy and could trigger some serious market upsets. Unlike the other central banks, which are responsible for one country, the ECB is looking after a currency for 19 different states each with their own fiscal policies, national characteristics and individual stages of economic development.
And the really big problem is how Italian bond yields will react. The country’s economy is due to grow a modest 1.3% this year, has a debt to GDP ratio of 132% and in 2015 spent 5.4% of its GDP on servicing debt, compared with 1% for Japan with a debt to GDP ratio of 250% (this is because Japan’s debt is cheaper to service). A doubling in interest rates, which is far from unbelievable, given how low they are, would probably begin to cripple Italy and trigger a new Eurozone crisis of potential epic proportions, which is why the ECB faces one of the hardest exits of all and would be extremely difficult if inflation was pushing above 2.0%.
Overall, the ECB may have to execute one of the slowest and most skilful exits of all the central banks so it doesn’t blow up the Eurozone.
TECHNICAL ANALYSIS: Another assault on EUR/USD 1.1445 looking likely
Although EUR/USD pulled back from highs of 1.1445, the trend still looks bullish with further attempts anticipated though it could be a few days or a week before that happens as the EUR is still looking over-bought at current levels.
The 1.1445 level is a crucial one for this exchange rate as it represents an important historic high and could therefore prove quite challenging to breach as traders will sell into it on the hope of covering their short positions on the pull-back, which is what has happened recently.
However, given the momentum and the fact that the current pattern looks more like a consolidation pattern, a breakthrough on 1.1445 still looks likely.
Resistance: 1.1439, 1.1445 and 1.1520 and Support 1.1338, 1.1284 and 1.1198
By Justin Pugsley, Markets Analyst MahiFX