Euro traps Draghi
By Peter Rosenstreich
Investors are bracing for an event-heavy day. Today’s highlight will clearly be the European Central Bank’s decision on Quantitative Easing (QE) stimulus. However, substantive information on the Bank’s monetary policy strategy are unlikely to come from this meeting. We had originally penciled in comments outlining the path towards normalization. The recent strength in Euro will keep the ECB focused on exchange rates and it will likely water down any discussion on extension of the Asset Purchase Program. While economic data has improved significantly in the EU, a slight delay to measure the market’s reaction against any Fed actions won’t meaningfully risk a surge in the inflation outlook.
Yet, encouraging the markets with hints of cutting QE purchases (even buffered with minimal extension) could send EUR/USD back above 1.20. We don’t think Draghi will take this risk. There is a case that Draghi is only delaying the inevitable and could start announcing an QE extension today to prepare the market for an eventual trimming of the size. Markets will likely dissect every sentence causing EUR volatility to increase, but the longer-term outlook indicates that the ECB needs to start a tightening policy. The Euro has become less sensitive to short-end yield movements; beneficial yields spread will send EUR/USD higher. Europe has enjoyed the advantages of a weaker Euro. Judging from the improvement in German industrial production (4.0% from 2.7% y/y) exports will need to adjust to a strong Euro moving forward.
Donald and Democrats make a deal
Finally, Wall Street is celebrating the removal of the immediate threat of a debt ceiling collapse. However, the real news was Trump working with Democrats. In rare bipartisan deal, Trump, Republicans and Democrats extended the U.S. debt limit and provided government funding until Dec. 15th. Should the Republican-led Congress pass the bill, the 3-month deal would prevent an extraordinary default on U.S. government debt and keep the government funded for the fiscal year starting Oct. 1.
This was a massive first step. True, it was tied to relief assistance for victims of Hurricane Harvey, but still, the path towards meaningful tax reform (and potentially other stimulus) just got a little less steep. We were perhaps premature in writing off the Trump pro-growth, reflation story – a shift to the center, highlighted by this 3-month extension, could be the start of something real. A unified US government could have profound effects on our market outlook.
Long SEK Riksbank delay
Elsewhere the Riksbank will keep to the sidelines in their rate decision. Sweden’s central bank is likely to let the ECB make the first move toward normalization. The Riksbank will likely copy Draghi’s balancing trick of acknowledging stronger economic growth without shifting policy strategy. However, as with Euro traders, the market will not likely be fooled by the delay. Sweden’s above-trend moves in growth and inflation indicate that monetary policy needs to tighten. As with the ECB, asset purchase program technicalities could actually be preventing the Riksbank from purchasing more assets. Any suggestion that market liquidity could handle further intervention would create a marginally dovish outcome and have a negative effect on the SEK. However, the most logical path for the Riksbank is a slow and steady removal of emergency measures and strong SEK.