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Euro: Thumbnail Sketch Ahead of the ECB Meeting

Euro:  Thumbnail Sketch Ahead of the ECB Meeting

The euro has traded between roughly $1.0485 and $1.1100 so far this year. The average is about $1.08, where it traded above yesterday for the first time in 2 ½ weeks.

Recall that the euro rallied from around $1.05 in mid-March (amid speculation that the banking stress was going to force the Fed to cut) to around $1.1100, where it stalled in late April and early May.

We argued that the rate cut expectations had swung too far and that as they converged back with the Fed the dollar would recover. The euro hit a low at the end of May near $1.0635.

The interest rate adjustment we anticipated looked complete or nearly so and that seemed to warn of the risk of a dollar setback/euro bounce.

The five- and 20-day moving average simple cross-over proxy has down very well this year. It cross higher in mid-March and lower in early May. The five-day moving average crossed above the 20-day moving average yesterday.

The ECB meets tomorrow. The swaps market is nearly certain (95%) that the ECB will hike key rates by 25 bp. This will lift the deposit rate to 3.50%. The ECB is expected to indicate that it recognizes more work is needed to bring inflation back to its target. The market has a little more than a 70% chance of at the July 27 meeting discounted, and, in any event, it is fully discounted by the end of Q3. This is expected to be the terminal rate now.

The ECB will announce new economic forecasts and the risk is that growth is cut, and inflation raised. There will also be an indication of how it will allow the assets purchased under the Asset Purchase Program (APP) will roll off starting in H2. Remember there are loans, under the Targeted Long-Term Refinancing Operations, which are due at the end of the month. This will result in a several hundred billion euro decline in the ECB’s balance sheet.

I have two nagging concerns about the euro. First, the US 2-year premium rose above a little above 170 bp yesterday, the most since March. I suspect it is near a high, but I have been thinking so since earlier this month. There is scope for it to rise a bit more to challenge the year’s high near 185 bp in early February. Its five-day moving average is above the 20-day moving average. Second, the net speculative long position in the futures market remains large (158.4k contracts) though it has been trimmed by 28.5k contracts over the past three weeks. Take away:  the discretionary market is still very long euros and interest rate differentials are moving against it.

If we use the current implied volatility and make a band around the implied forward, it produces a band of roughly $1.0350-$1.1475. Mathematically, assuming vol stays constant and the outcome is normally distributed, there is about a 72% chance the euro finishes the year in that range. The median forecast in Bloomberg’s survey is for it to be at $1.12, up a cent from a month ago. 

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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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