ECB dovish guidance: a game changer for the euro

The European Central Bank’s policy communication on 7 March was a game changer for the EUR. We revise substantially lower our EURUSD forecast for 2019: near-term we see better-than-even odds for a convergence towards the 1.10 level and anticipate a modest recovery only in the second half of this year. Our year-end target now stands at 1.14 (1.20 previously).

Yesterday, the ECB delivered “shock and awe” by abruptly turning controlled cautiousness into full-blown dovishness. We will first summarise the key points from the ECB’s policy meeting and then elaborate on EUR implications (including changes to our forecasts). We conclude with our view on the broader implications for the FX universe.

Four key points on policy changes

1. Real GDP growth expectations for 2019 were revised substantially lower, from 1.7% to 1.1%. The lower growth trajectory now means it will take longer to meet the inflation target. Inflation for 2019 is now seen at 1.2% (1.6% previously), and is not expected to exceed 1.6% over the next three years.
2. The ECB significantly changed its forward guidance, with rates now seen on hold at least through the end of 2019 (the previous guidance was “at least through the summer of 2019”).
3. The ECB announced a third round of Targeted Long Term Refinancing Operations (TLTRO III) which will avoid the cliff-edge expiry of the second round of TLTROs at the end of June and ensure fluid lending conditions. These TLTROs will be conducted every quarter from September 2019 through March 2021, with a 2-year maturity.
4. Finally, reinvestments of maturing debt (approximately EUR 20 billion per month) will last longer than planned to keep the ECB’s balance sheet constant.

EUR implications

The TLTRO announcement was not really a surprise, although we expected the formal communication to come a little later (potentially at the April meeting). However, the ECB turned the tide on the currency with its substantial downgrade of growth/inflation forecasts and its altered forward guidance. We view this as game-changing for the EUR (at least for the next six months or so) as it opens the door to the current negative interest rate policy remaining in place for longer than initially expected. EURUSD sold-off on the news, diving from 1.1320 to 1.1180 before stabilising around the 1.12 level.

We have long argued that EURUSD upside (until now our central scenario) was more about dollar weakness than strong idiosyncratic euro area factors. Of course, slackening external headwinds (such as trade) would also help by allowing the euro area’s economic data to normalise. Although our broader dollar view of a slow depreciation throughout 2019 remains unchanged, we now believe that the ECB’s policy shift represents a huge hurdle for the common currency to find its footing. Importantly, past experience suggests that Mr Draghi’s well-articulated dovishness has had a noticeable and lasting negative impact on the currency.

As such, we now think that chances are more than even that EURUSD will converge lower towards 1.10 by the end of this quarter and potentially stabilise around 1.12 at the end of Q2 19 (compared with 1.16 previously). We still expect the external headwinds of weaker trade to normalise over the next few quarters (and so we think the ECB’s new growth forecast is too pessimistic) but any euro recovery is unlikely before the second half of this year. We pencil-in 1.13 for Q3 19 (1.18 previously) and 1.14 for Q4 19 (1.20 previously). By that time, we judge that the modest improvement in global trade and continuing sound domestic fundamentals will be enough to allow the ECB to start unwinding some of its recent dovishness. Of course, we do not now expect a deposit rate hike this year. Inevitably, any failure in global trade data to stabilise would put these forecasts under significant downside pressure.

Broader FX implications

More broadly, it is hard to ignore this new wave of major central bank dovishness from the Federal Reserve, the ECB, the Bank of Canada, and to a certain extent, the Bank of Japan. This is bound to have implications for risk and risk currencies, although through different and potentially offsetting channels.

On one hand, this renewed and broad-based dovish stance implies that monetary policies will remain accommodative for longer. This should be good for risk and emerging market FX more widely. On the other hand, the increased pessimism communicated by central banks is sending alarm signals to the investment community about global growth prospects and could weigh on risk sentiment (for example following the ECB policy communication and the disappointing overnight Chinese trade figures, USDJPY fell from 111.86 to 110.95).

There seems to be a battle between liquidity remaining plentiful for longer (which is risk positive) and concerns over global trade and growth (which is risk negative). In our view, recent developments in the US-China trade discussions have increased the chances of data normalisation followed by a modest recovery. If we are right, then the effect on risk should be a net positive and maintain the recent pickup in portfolio flows towards emerging markets. The latter should bode well for emerging market FX carry trades. That said, with the ECB communicating that rates will remain negative for longer, it now makes more sense to chase higher-yielding EM currencies through funding of euros.

Finally, the ECB’s (indirect) blow to the exchange rate has implications for EURGBP given the upcoming developments on Brexit. Our new EURUSD trajectory implies that EURGBP will reach 0.82 around the middle of the year with risks skewed to the downside. Of course, this is under our working assumption that there will be an extension of article 50 agreed in the UK parliament next week (and approved by the EU) and eventually, negotiations over the next three or four months that lead to a sort of a ‘soft Brexit’. If correct, this would allow sterling to appreciate by pricing-out the ‘hard Brexit’ risk premia while the EUR continues to remain under pressure from the ECB’s newly dovish forward guidance.