EURUSD stumbled despite a less dovish ECB hold

On Thursday (25th January), some focus of the market was on the ECB’s monetary policy decision ahead of the Fed’s expected hawkish hold on 31st January. As unanimously expected, on Thursday ECB held all key policy rates; i.e. reference interest rates on the main refinancing operations (MRO-interbank rate) at +4.50%; interest rates on the marginal lending facility (MLF-repo rate) at +4.75%, and interest rate on deposit facility (DRF-reverse repo) at +4.00%, all are at 22-years high (since Oct’2008) after 10th consecutive rate hikes till Sep’23 (cumulating +450 bps since July’22).

The ECB kept all policy rates unchanged at record-high levels during its first meeting of 2024 and pledged to maintain them at sufficiently restrictive levels for as long as necessary to bring inflation back to its 2% target promptly, despite concerns about a looming recession. The main refinancing operations rate (MRO) remained at a 22-year high of 4.5% for a third consecutive time, while the deposit facility rate (DRF) held steady at a record of 4%. The ECB maintained interest rates at multi-year highs for the third consecutive meeting and signaled an early conclusion to its last remaining bond purchase scheme under PEPP. The ECB reiterated full reinvestment under the PEPP (backdoor QE) will end on 30th June and subsequent QT of the PEPP portfolio by €7.5B/Month till Dec’24.

 

ECB REPO/LENDING RATE AT 4.75%

During the ECB’s post-policy presser, President Lagarde said officials unanimously concluded that it was premature to engage in discussions regarding interest rate cuts (despite market pricing of multiple rate cuts cumulatively around -125 bps in 2024). The ECB has remained on a hawkish hold stance officially since Sep’23 due to persistent underlying core inflation pressures within the Eurozone and uncertainties stemming from lingering geopolitical tensions, including the Red Sea blockade, Gaza and Ukraine war.

ECB policymakers have also pledged to maintain current policy rates at sufficiently restrictive levels for as long as necessary to bring inflation down towards targets. The ECB has projected inflation (HICP) to average 5.4% in 2023, 2.7% in 2024, 2.1% in 2025 and 1.9% in 2026. The core inflation/HICP rate is seen at 5.0% in 2023, 2.7% in 2024, 2.3% in 2025, and 2.1% in 2026; i.e. by target in 2025 (in line with Fed’s projections).

On Thursday, during the post-policy meeting presser/Q&A, ECB President Lagarde again said that policymakers/Governing Council (GC) did not discuss any rate cuts as it would be speculative & premature at this stage, reiterating that future decisions would be data-dependent (not Fed-dependent). The market was pricing around a -150 bps rate cut by the ECB in 2024 (in line with Fed), but Lagarde trashed away the present market pricing of -150 bps rate cuts in 2024.

Overall, like the Fed, the ECB also indicated they are at the peak of the terminal rate, which is now at a restrictive zone and has to maintain for sufficient time so that inflation will gradually fall to +2.0% targets. But unlike the Fed, the ECB denied any official discussion about any rate cuts at this point, terming it as premature.

Thus overall, it may be termed as a synchronized hawkish hold (higher for longer); the same stance is being taken by all other major G4 central banks like the Fed, BOE, and BOC to ensure tighter financial conditions, higher borrowing costs and lower inflation expectations/lower demand/return to price stability without causing a hard landing.

Full Text of ECB statement: Monetary policy decisions: 25th Jan’24

“The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information has broadly confirmed its previous assessment of the medium-term inflation outlook. Aside from an energy-related upward base effect on headline inflation, the declining trend in underlying inflation has continued, and the past interest rate increases keep being transmitted forcefully into financing conditions. Tight financing conditions are dampening demand, and this is helping to push down inflation.

The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. Based on its current assessment, the Governing Council considers that the key ECB interest rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to this goal. The Governing Council’s future decisions will ensure that its policy rates will be set at sufficiently restrictive levels for as long as necessary.

The Governing Council will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, the Governing Council’s interest rate decisions will be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.

Key ECB interest rates

The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 4.50%, 4.75% and 4.00% respectively.

Asset purchase programme (APP) and pandemic emergency purchase programme (PEPP)

The APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities.

The Governing Council intends to continue to reinvest, in full, the principal payments from maturing securities purchased under the PEPP during the first half of 2024. Over the second half of the year, it intends to reduce the PEPP portfolio by €7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.

The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.

Refinancing operations

As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations and their ongoing repayment are contributing to its monetary policy stance.

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The Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its 2% target over the medium term and to preserve the smooth functioning of monetary policy transmission. Moreover, the Transmission Protection Instrument is available to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries, thus allowing the Governing Council to more effectively deliver on its price stability mandate.

Text of the opening statement by ECB President Lagarde: 25th Jan’24

“The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information has broadly confirmed our previous assessment of the medium-term inflation outlook. Aside from an energy-related upward base effect on headline inflation, the declining trend in underlying inflation has continued, and our past interest rate increases keep being transmitted forcefully into financing conditions. Tight financing conditions are dampening demand, and this is helping to push down inflation.

We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. Based on our current assessment, we consider that the key ECB interest rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to this goal. Our future decisions will ensure that our policy rates will be set at sufficiently restrictive levels for as long as necessary.

We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.

The decisions taken today are set out in a press release available on our website.

I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions.

Economic activity

The euro area economy is likely to have stagnated in the final quarter of 2023. The incoming data continue to signal weakness in the near term. However, some forward-looking survey indicators point to a pick-up in growth further ahead.

The labour market has remained robust. The unemployment rate, at 6.4 percent in November, has fallen back to its lowest level since the start of the euro and more workers have entered the labor force. At the same time, demand for labor is slowing, with fewer vacancies being advertised.

Governments should continue to roll back energy-related support measures to avoid driving up medium-term inflationary pressures. Fiscal and structural policies should be designed to make our economy more productive and competitive, as well as to gradually bring down high public debt ratios. Structural reforms and investments to enhance the euro area’s supply capacity – which would be supported by the full implementation of the Next Generation EU programme – can help reduce price pressures in the medium term, while supporting the green and digital transitions.

Following the recent ECOFIN Council agreement on the reform of the EU’s economic governance framework, the legislative process should be concluded swiftly so that the new rules can be implemented without delay. Moreover, progress toward the Capital Markets Union and the completion of the Banking Union must be accelerated.

Inflation

Inflation rose to 2.9 percent in December as some of the past fiscal measures to cushion the impact of high energy prices dropped out of the annual inflation rate, although the rebound was weaker than expected. Aside from this base effect, the overall trend of declining inflation continued. Food price inflation dropped to 6.1 percent in December. Inflation excluding energy and food also declined again, to 3.4 percent, due to a fall in goods inflation to 2.5 percent. Services inflation was stable at 4.0 per cent.

Inflation is expected to ease further over this year as the effects of past energy shocks, supply bottlenecks and the post-pandemic reopening of the economy fade, and tighter monetary policy continues to weigh on demand.

Almost all measures of underlying inflation declined further in December. The elevated rate of wage increases and falling labor productivity are keeping domestic price pressures high, although these too have started to ease. At the same time, lower unit profits have started to moderate the inflationary effect of rising unit labor costs. Measures of shorter-term inflation expectations have come down markedly, while those of longer-term inflation expectations mostly stand around 2 percent.

Risk assessment

The risks to economic growth remain tilted to the downside. Growth could be lower if the effects of monetary policy turn out stronger than expected. A weaker world economy or a further slowdown in global trade would also weigh on euro area growth. Russia’s unjustified war against Ukraine and the tragic conflict in the Middle East are key sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted. Growth could be higher if rising real incomes mean spending increases by more than anticipated, or if the world economy grows more strongly than expected.

Upside risks to inflation include heightened geopolitical tensions, especially in the Middle East, which could push energy prices and freight costs higher in the near term and hamper global trade. Inflation could also turn out higher than anticipated if wages increase by more than expected or profit margins prove more resilient.

By contrast, inflation may surprise on the downside if monetary policy dampens demand by more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Moreover, inflation could decline more quickly in the near term if energy prices evolve in line with the recent downward shift in market expectations of the future path for oil and gas prices.

Financial and monetary conditions

Market interest rates have moved broadly sideways since our last meeting. Our restrictive monetary policy continues to transmit strongly into broader financing conditions. Lending rates on business loans declined slightly, to 5.2 per cent in November, while mortgage rates increased further to 4.0 per cent.

High borrowing rates, with the associated cutbacks in investment plans and house purchases, led to a further drop in credit demand in the fourth quarter, as reported in our latest bank lending survey. While the tightening of credit standards for loans to firms and households moderated, they remained tight, with banks concerned about the risks faced by their customers.

Against this background, credit dynamics have improved somewhat but overall remain weak. Loans to firms stagnated in November compared with a year earlier – after contracting in October – as the monthly flow of short-term loans rebounded. Loans to households grew at a subdued annual rate of 0.5 per cent.

Conclusion

The Governing Council today decided to keep the three key ECB interest rates unchanged. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner.Based on our current assessment, we consider that the key ECB interest rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to this goal. Our future decisions will ensure that our policy rates will be set at sufficiently restrictive levels for as long as necessary. We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission.”

Highlights of ECB President Lagarde’s comments during Q&A (Presser): 25th Jan’24

·         Credit dynamics have improved somewhat but remain weak

·         Inflation could fall more quickly if energy prices evolve in line with the recent downward shift

·         Wages and profit margins would also be upside price risks

·         Geopolitical tensions in the Middle East are an upside risk to inflation

·         Longer-term inflation term expectations mostly stand around 2%

·         Domestic price pressures are high but some measures have started to ease

·         Almost all underlying inflation measures fell in December

·         Inflation is expected to ease further over 2024

·         The December inflation rebound was weaker than expected

·         The new budget rules should be implemented without delay

·         The demand for labor is slowing

·         Some surveys point to growth further ahead

·         The labour market is robust

·         The economy is likely to have stagnated in Q4

·         I'm seeing a slight reduction in the number of vacancies advertised

·         I'm seeing some stabilization in the wage tracker

·         Risks to economic data remain tilted to the downside

·         The consensus at the table is that it's premature to talk about rate cuts

·         Domestic price pressures are high but some measures have started to ease

·         Almost all underlying inflation measures fell in December

·         Inflation is expected to ease further over 2024

On Thursday, Lagarde was asked by her comments a week before in Davos/BBG about a possible ECB rate cut from summer (June-September), which is in line with other ECB policy makers-whether the ECB discussed it officially and whether there would be no cut in March/April-Lagarde replied:

“First of all, the consensus around the table of the Governing Council was that it was premature to discuss rate cuts. In addition to that, I typically stand by my comments. So the comments I made to your television channel, Bloomberg, I certainly stand by them. I’m not sure that I would exactly characterize them as you have, but I stand by what I have said, not what others have commented that I have said.

One other thing that was very much the consensus around the table was that we had to continue to be data-dependent. So rather than being fixated on any kind of particular calendar, which would be date-dependent, we reaffirmed our data dependency. And I have flagged in the course of the monetary policy statement some of the areas that we will be particularly attentive to in the course of the next few months.”

On Thursday, although Lagarde said the discussion of rate cuts in the ECB GC is pre-mature at this stage, she didn’t trash away any rate cuts in the summer and also kept the March-April meeting alive citing data-dependency. Money markets priced in -140 bps of rate cuts in 2024 from -130 bps before the ECB statement; also now seeing -50 bps of easing by June.

Conclusions:

In Dec’23, the annual core CPI fell to +3.4% from +5.3% in Jan’23.

Looking at the previous sequential run rate trend, the average core CPI in 2023 should be around +5.1%, while it may reach around +3.0% by Dec’24 and +2.2% by Dec’25 in line with ECB projections. For this to happen, the average sequential core CPI would have to fall from present +0.35% to +0.25% in 2024 and +0.20% in 2025. Thus there is a need to maintain a real positive rate, restrictive enough to bring inflation back to +2.0% targets by early 2026 or at least till Dec’25.

Europe/EU is the real victim of the Russia-Ukraine and Israel-Hamas war as it’s an import-oriented economy for both fuel and food; i.e. imported inflation is the main issue here amid weaker EURUSD. Euro Area economy may be now in a stagflation-like situation (lower/negative economic growth and higher inflation). Apart from supply chain disruptions, Eurozone core inflation was also boosted by wage growth, pent-up demand, especially for services, and increasing pricing power of producers. EU is the biggest loser of the lingering Russia-Ukraine/NATO war/proxy war as it’s a net importer of both food and fuel coupled with other commodities and a weaker EUR.

As per Taylor’s rule, for the Eurozone:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.0-2.00) =0+2+3.0=5.0%

Here for EU /ECB

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= Estimated average core inflation=5.0% (for 2023~4.95%)

The repo rate of the ECB is now at +4.75% against Taylor’s rule suggestion of +5.0%. Growing real policy divergence between the Fed and ECB along with a stagflation-like scenario in the EU may keep EURUSD lower in the coming days, causing more imported inflation as the EU depends on both fuel and food imports.

Now all major G4 central banks; i.e. Fed, ECB, BOE, and BOC are expected to continue on a hawkish hold position in 2024, till at least H1CY24 and if core inflation comes down as expected by then, we may see some rate cuts from July’24 by all of them and effectively by all other major G20 central banks. However, the ECB has to maintain a real positive rate in 2024 from the actual core CPI (at least 6M average) to bring a price stability target.

Bottom Line:

ECB may cut rates from July’24; i.e. in H2CY24 for a cumulative 75-100 bps in line with Fed.

Technical trading levels: EURUSD

Whatever the narrative, technically EURUSD (1.08400) now has to sustain above 1.07900 for a recovery to 1.08800-109300 and further 1-09800/1.10000-1.10500/1.11400; otherwise sustaining below 1.07700, may further fall to around 1.07200/1.06500-1.06200/1.06000 in the coming days.