EURUSD surged on a hawkish hold by ECB; Dow at lifetime high

On Thursday (14th December), all focus was on the ECB’s monetary policy decision after a dovish hold by Fed a day before, in which Fed indicated -75 bps rate cuts in 2024, most probably from June’24. Although the market was expecting around -100 bps rate cuts by Fed in 2024 before the Fed decision, it was boosted by -150 bps soon after Fed Chair Powell concluded his post-policy presser/Q&A, in which Powell didn’t attempt to present market pricing of an early rate cut in 2024 as ‘speculative & premature’ contrary to his last public comments 1st December, barely 12-days earlier, when Powell even batted for ‘higher for longer’ policy.

In a way, after the Fed indicated -75 bps rate cuts in 2024, the market was expecting a similar dovish hold stance by the ECB Thursday. As the Fed is the world’s unofficial central bank because the USD is the ‘King’ (the world’s most preferred FX or global reserve currency), all major G20 central banks are now bound to follow the Fed policy stance to maintain present policy/currency/bond yield parity, everything being equal. Thus the market is now expecting a synchronized global loosening (rate cuts) by major G20 global central banks including ECB, BOE, BOC, PBOC and even India’s RBI, whatever may be the domestic macro-economic narrative (just like post-COVID synchronized global tightening to bring inflation down to targets).

Higher USD against any domestic currency is positive for imported inflation and vice-versa. Thus if an economy like the EU, which is dependent on imported food & fuel and also other vital commodities refrains from following the Fed’s policy stance/actual rate actions for long, it will affect domestic currency against USD and imported inflation. During post-COVID rapid Fed tightening, the ECB initially wasted 3 months following the Fed’s rate hike actions on soft core inflation narrative and the result is known to everyone later; EU’s imported inflation jumped because of weaker EUR against USD coupled with ‘unjustified’ Russia-Ukraine war. This time too, if the ECB does not follow the Fed’s policy action of possible -75 bps rate cuts in 2024 along with the end of QT, the EUR will soar against USD, which may cause not only too much disinflation, but also subdued export activities, and as an export savvy service economy, EU may even fall into deflation like scenario.

On Thursday as unanimously expected, the 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 maintained interest rates at multi-year highs for the second consecutive meeting and signaled an early conclusion to its last remaining bond purchase scheme under PEPP. The main refinancing operations rate remained at a 22-year high of 4.5%, while the deposit facility rate held steady at a record of 4%. The ECB also said full reinvestment under the PEPP (backdoor QE) will end on 30th June (contrary to the earlier notion of continuity till at least Dec 24). ECB also announced QT of PEPP portfolio by €7.5B/Month till Dec’24.

ECB policymakers have also pledged to maintain current 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 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 -150 bps rate cut by ECB in 2024 (in line with Fed), but ailing & fragile-looking Lagarde, just recovering from COVID/acute bronchitis, basically trashed away the present market pricing of -150 bps rate cuts in 2024. Subsequently, EURUSD surged from around 1.09000 to 1.10000 on hopes of continuous policy divergence with the Fed.

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 hawkish hold (higher for longer); the same stance is being taken by all other major G4 central banks like the Fed (until the 13th December Fed meeting), 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: 14th December’2023

“The Governing Council today decided to keep the three key ECB interest rates unchanged. While inflation has dropped in recent months, it is likely to pick up again temporarily in the near term. According to the latest Eurosystem staff projections for the euro area, inflation is expected to decline gradually over the course of next year, before approaching the Governing Council’s 2% target in 2025. Overall, staff expects headline inflation to average 5.4% in 2023, 2.7% in 2024, 2.1% in 2025 and 1.9% in 2026. Compared with the September staff projections, this amounts to a downward revision for 2023 and especially for 2024.

Underlying inflation has eased further. But domestic price pressures remain elevated, primarily owing to strong growth in unit labor costs. Eurosystem staff expects inflation excluding energy and food to average 5.0% in 2023, 2.7% in 2024, 2.3% in 2025 and 2.1% in 2026.

The past interest rate increases continue to be transmitted forcefully to the economy. Tighter financing conditions are dampening demand, and this is helping to push down inflation. Eurosystem staff expects economic growth to remain subdued in the near term. Beyond that, the economy is expected to recover because of rising real incomes – as people benefit from falling inflation and growing wages – and improving foreign demand. Eurosystem staff therefore sees growth picking up from an average of 0.6% for 2023 to 0.8% for 2024 and to 1.5% for both 2025 and 2026.

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, its 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.

The key ECB interest rates are the primary tool for setting the monetary policy stance. The Governing Council also decided today to advance the normalization of the Eurosystem’s balance sheet. It intends to continue to reinvest, in full, the principal payments from maturing securities purchased under the pandemic emergency purchase programme (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.

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.

***

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: 14th December’2023

“The Governing Council today decided to keep the three key ECB interest rates unchanged. While inflation has dropped in recent months, it is likely to pick up again temporarily in the near term. According to the latest Eurosystem staff projections for the euro area, inflation is expected to decline gradually over the course of next year, before approaching our two per cent target in 2025. Overall, staff expects headline inflation to average 5.4 percent in 2023, 2.7 percent in 2024, 2.1 percent in 2025 and 1.9 percent in 2026. Compared with the September staff projections, this amounts to a downward revision for 2023 and especially for 2024.

Underlying inflation has eased further. But domestic price pressures remain elevated, primarily owing to strong growth in unit labor costs. Eurosystem staff expects inflation excluding energy and food to average 5.0 percent in 2023, 2.7 percent in 2024, 2.3 percent in 2025 and 2.1 percent in 2026.

Our past interest rate increases continue to be transmitted forcefully to the economy. Tighter financing conditions are dampening demand, and this is helping to push down inflation. Eurosystem staff expects economic growth to remain subdued in the near term. Beyond that, the economy is expected to recover because of rising real incomes – as people benefit from falling inflation and growing wages – and improving foreign demand. Eurosystem staff therefore sees growth picking up from an average of 0.6 per cent for 2023 to 0.8 per cent for 2024, and to 1.5 per cent for both 2025 and 2026.

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 key ECB interest rates are our primary tool for setting the monetary policy stance. We also decided today to advance the normalization of the Eurosystem’s balance sheet. The Governing Council intends to continue to reinvest, in full, the principal payments from maturing securities purchased under the pandemic emergency purchase programme (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.

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 contracted slightly in the third quarter, mostly owing to a decline in inventories. Tighter financing conditions and subdued foreign demand are likely to continue weighing on economic activity in the near term. Prospects are especially weak for construction and manufacturing, the two sectors most affected by higher interest rates. Services activity is also set to soften in the coming months. This is due to spillovers from weaker industrial activity, fading effects from the reopening of the economy, and the broadening impact of tighter financing conditions.

The labour market continues to support the economy. The unemployment rate stood at 6.5 percent in October and employment grew by 0.2 percent over the third quarter. At the same time, the weaker economy is dampening the demand for workers, with firms advertising fewer vacancies in recent months. Moreover, even though more people are at work, the total number of hours worked edged down by 0.1 percent in the third quarter.

As the energy crisis fades, governments should continue to roll back the related support measures. This is essential to avoid driving up medium-term inflationary pressures, which would otherwise call for even tighter monetary policy. Fiscal policies should be designed to make our economy more productive and to gradually bring down high public debt.

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. To that end, it is important to swiftly agree on the reform of the EU’s economic governance framework. Moreover, progress toward the Capital Markets Union and the completion of the Banking Union must be accelerated.

Inflation

Inflation dropped over the past two months, falling to an annual rate of 2.4 percent in November according to Eurostat’s flash release. This decline was broad-based. Energy price inflation fell further and food price inflation also came down, despite remaining relatively high overall. This month, inflation is likely to pick up on account of an upward base effect for the cost of energy. In 2024, we expect inflation to decline more slowly because of further upward base effects and the phasing-out of past fiscal measures aimed at limiting the repercussions of the energy price shock.

Inflation excluding energy and food dropped by almost a full percentage point over the past two months, falling to 3.6 percent in November. This reflects improving supply conditions, the fading effects of the past energy shock and the impact of tighter monetary policy on demand and the pricing power of firms. The inflation rates for goods and services fell to 2.9 per cent and 4.0 per cent respectively.

All measures of underlying inflation declined in October, but domestic price pressures remained elevated, chiefly because of strong wage growth together with falling productivity. Measures of longer-term inflation expectations mostly stand around 2 percent, with some market-based indicators of inflation compensation declining from elevated levels.

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. Growth could be higher if rising real incomes raise spending by more than anticipated, or if the world economy grows more strongly than expected.

Upside risks to inflation include heightened geopolitical tensions, which could raise energy prices in the near term, and extreme weather events, which could drive up food prices. Inflation could also turn out higher than anticipated if inflation expectations were to move above our target, or if wages or profit margins increased by more than expected. By contrast, inflation may surprise on the downside if monetary policy dampens demand by more than expected or the economic environment in the rest of the world worsens unexpectedly, potentially owing in part to the recent rise in geopolitical risks.

Financial and monetary conditions

Market interest rates have fallen markedly since our last meeting and lie below the rates embedded in the staff projections. Our restrictive monetary policy continues to transmit strongly into broader financing conditions. Lending rates rose again in October, to 5.3 percent for business loans and 3.9 percent for mortgages.

Higher borrowing rates, subdued loan demand, and tighter loan supply have further weakened credit dynamics. Loans to firms declined at an annual rate of 0.3 percent in October and loans to households also remained subdued, growing at an annual rate of 0.6 percent. With weaker lending and the reduction in the Eurosystem balance sheet, broad money – as measured by M3 – has continued to contract. In October it fell at an annual rate of 1.0 per cent.

In line with our monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks have demonstrated their resilience. They have high capital ratios and have become significantly more profitable over the past year. However, the financial stability outlook remains fragile in the current environment of tightening financing conditions, weak growth and geopolitical tensions. In particular, the situation could worsen if banks’ funding costs were to increase by more than expected and if more borrowers were to struggle to repay their loans. At the same time, the overall impact of such a scenario on the economy should be contained if financial markets react in an orderly fashion. The macroprudential policy remains the first line of defense against the build-up of financial vulnerabilities, and the measures in place contribute to preserving the financial system’s resilience.

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 rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target. Our future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary to ensure such a timely return. We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction.

The Governing Council intends to reduce the PEPP portfolio over the second half of 2024 and to discontinue its reinvestments under the PEPP at the end of 2024. 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): 14th December’2023

·         Services activity is to soften in the coming months

·         Prospects are especially weak for rate-sensitive construction and manufacturing sector

·         Tighter financing conditions weigh on the economy

·         In December, inflation is likely to pick up (base effect)

·         Inflation is to decline more slowly in 2024

·         The inflation decline was broad-based

·         Risks to growth are skewed to the downside

·         Most measures of longer-term inflation expectations currently stand at around 2%

·         Inflation may surprise on the downside if monetary policy depresses activity more than expected

·         Adverse Weather events could drive up food prices

·         Upside risks to inflation include geopolitical tensions

·         The financial stability outlook remains fragile

·         A lot of indicators show underlying inflation below expectations

·         The inflation path is flatter than before, lowers the risk of expectations de-anchoring

·         Domestic inflation is hardly budging

·         Some governors would have liked different tapering, earlier or later

·         This is a good moment for PEPP change

·         We need to see more data on wages

·         We did not discuss rate cuts

·         We don't think it's time to lower guard, there's still work to be done. This can take the form of holding rates

·         We don't have a recession in our baseline

·         We wouldn't hesitate to use other tools to preserve transmission

·         ECB will pay utmost attention to the 2024 wage agreement/tracker/growth

·         ECB’s latest projections of 2% core/HICP inflation by 2025 based on current interest rate path (restrictive levels)

·         ECB's mandate is to reach the medium-term target of 2% inflation/price stability target without causing a recession

Notable full quotes by Lagarde in the Q&A:

“We did not discuss rate cuts at all. No discussion, no debate on this issue. And I think everybody in the room takes the view that between hike and cut, there's a whole plateau, a whole beach of hold. It's like solid, liquid, and gas: you don't go from solid to gas without going through the liquid phase. This was just not discussed. I think going forward; we are going to continue to be data-dependent. We are going to continue to determine meeting by meeting what we see on the totality of data. But, given a certain resistance of domestic inflation and the risk of second-round effects that we want to avoid, we're going to be very attentive to that category of data that I have just described.”

“---with the wage and profit question, because it's something that staff – both here at the ECB but also in the national central banks – looks at very, very carefully. And what we have seen is a contribution from unit profits to inflation declining throughout 2023. From memory, the contribution was at about 2.4% and it's now down to 1.4%. Now, it’s a big “if” and we need to understand and make sure that this is sustainable, but if that is confirmed, it would mean that the hypotheticals that we had in our previous forecast and that we have for this forecast in December – which was that markups would be reduced to absorb increased wages by way of catch-up or otherwise – that that is actually taking place, which would be really good news for inflation purposes. But we don't have enough on the table to really determine that this is what is going to happen. We will.”

Customary ECB source after ECB Presser:

·         The ECB is largely united on seeing rate cuts later than market bets

·         Policymakers at the ECB are largely in agreement that interest rates will be cut later than financial markets currently anticipate

·         This week's Governing Council discussions included some agitation over aggressive bets on lower borrowing costs, and some members were perplexed by the extent of easing priced in by investors

Conclusions:

ECB blinked after seeing EURUSD approaching the 1.10 redline as a result of hawkish jawboning by Lagarde. ECB contradicted Lagarde by intentionally acknowledging preliminary discussions about rate cuts. ECB has to cut -75 bps in 2024 in line with the Fed to keep policy differential at present levels, everything being equal and irrespective of any inflation narratives.

Market wrap:

On Thursday, EURUSD surged on a hawkish hold by the ECB, especially hawkish comments by Lagarde. Wall Street (US stocks) was undercut by hotter-than-expected November retail sales and softer-than-expected jobless claims data. But US stocks eventually recovered to close at a fresh lifetime high as the Santa Rally was further boosted by the Fed pivot and hopes of an early end of the Gaza war amid intensified global pressure on Israel and the U.S.

Bottom line:

Technical trading levels: EURUSD

Whatever the narrative, technically EURUSD (1.0990) now has to sustain above 1.10500 for a further rally to 1.11500/1.12100-1.12500/1.12800 in the coming days; otherwise sustaining below 1.10400-1.10200, may again fall to around 1.09200/1.08300-1.07600/1.07100 and 1.06500/1.05000-1.04400/1.04000 levels in the coming days.