ECB policy meeting is unlikely to trigger further pick-up in FX volatility

USD: China policy support triggers setback for US dollar

It has been a more volatile couple of days in the FX market. The US dollar suffered a sharp sell-off yesterday resulting in the dollar index falling to a low of 102.77 as it moved further below the high from the previous day of 103.82 although it has since recovered some of those losses. The US dollar sell-off appears to have been driven both by the paring back of investor pessimism over the outlook for China’s economy, and a drop in short-term US yields. The announcement yesterday from the PBoC that they will lower the reserve requirement ratio by a larger than expected 0.50 point which quickly followed the Bloomberg report stating that domestic policymakers are also putting together a package of measures to support the Chinese equity market has fuelled speculation that it could be the start of a series of more “forceful” policy steps that will help to ease downside risks for China’s economy. At the very least the latest developments have helped to temporarily ease investor pessimism towards China’s economy and Chinese assets that had been building at the start of this year. After hitting a year to date low on Tuesday, the Shanghai composite equity index has rebounded by around +6.6% and reversed most of the year to date losses.   

At the same time, the US dollar was undermined as well yesterday by a temporary drop in short-term US yields. The yield on the 2-year Treasury bond briefly fell to a low yesterday of 4.29% but has since picked back up to 4.37%. The move lower in US yields proved short-lived as further evidence emerged that the US economy is continuing to prove more resilient than expected. The composite PMI survey for the US economy improved by a larger than expected 1.4 point to 52.9 in January, and it reached the highest level since June of last year. The survey adds to evidence such as the recent drop in initial claims, and improvement in housing market activity suggesting that the US economy could even be regaining upward momentum at the start of this year after it appears to have slowed less than expected in Q4. The Q4 GDP report will be released this afternoon and the consensus forecast is for growth to slow to 2.0% following blow out growth of 4.9% in Q3.

EUR/USD VS. SHORT-TERM YIELD SPREAD

Source: Bloomberg, Macrobond & MUFG GMR

EUR: ECB to reiterate that rate cuts are unlikely until the summer

The other main focus this afternoon will be the ECB’s latest policy meeting. Ahead of today’s policy meeting, the release yesterday of the latest euro-zone PMI surveys for January revealed that business confidence remained weak at the start of this year. The composite PMI increased less than expected by 0.3 point to 47.9. It has averaged 47.7 over the last three months which represents only a marginal improvement from the average over the previous three months to October of 46.8. At current levels it continues to signal that the euro-zone economy could contract again in Q1. The release next week of the Q4 GDP report could reveal that the euro-zone economy fell into a mild technical recession in the second half of last year.

Despite the weak performance of the euro-zone economy, the ECB is still expected to present a relatively hawkish update at today’s policy meeting. There has been a busy schedule of ECB speakers in recent weeks who have delivered a unified message in pushing back against premature rate cut expectations. ECB officials have indicated that they want to see more evidence that wage growth is moderating at the start of this year before becoming more confident that they can begin to lower rates. President Lagarde sent a clear message over the potential timing of the first ECB rate cut when she stated that they plan to cut rates in the summer. We expect this message to be repeated at today’s policy meeting and for the ECB to continue to flag upside risks to inflation from geopolitical risks in the Middle East. The updated guidance from the ECB suggests that the earliest point at which the ECB is planning to cut rates is from the June although market participants are still pricing in a high probability that the first cut could be delivered even earlier in April (there are currently around 18bps of cuts priced in by then). It should mean that today’s ECB policy is more of a holding operation like yesterday’s BoC policy meeting which is likely to have limited impact on the performance of the euro.         

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
GE	09:00	German Ifo Business Climate Index	Jan	86.7	86.4	!!
NO	09:00	Interest Rate Decision	--	--	4.50%	!!
EC	13:15	Deposit Facility Rate	Jan	4.00%	4.00%	!!!
US	13:30	Building Permits	--	1.495M	1.467M	!!
US	13:30	GDP (QoQ)	Q4	2.0%	4.9%	!!!
US	13:30	Initial Jobless Claims	--	200K	187K	!!!
EC	13:45	ECB Press Conference	--	--	--	!!!

Source: Bloomberg