Dollar soars after ECB aggressive easing suprises markets
08/Sep/2014 • Currency Updates•
Volatility returned with a vengeance to FX markets last week. Sterling began the fireworks earlier in the week, as polls began to show that the Yes option in the referendum for Scottish independence was gaining the lead up to the vote. On Thursday, the ECB added fuel to the dollar rally by cutting rates, announcing the launch of yet another monetary easing program, and stating that the economic risks in the Eurozone were now firmly “to the downside”. We had expected these moves but markets clearly had not and the euro dropped sharply against the dollar, breaching the psychological level of 1.30.
A weaker than expected payroll report in the US took some of the steam off the greenback’s rally, but it still ended the week up 1.5% against both the euro and the pound, and at least 1% higher against most other major currencies.
After last week, YouGov poll indicated a late surge in the Yes vote, the Scottish referendum has become the focus of UK financial markets. The latest poll by the same firm over the weekend actually showed the Yes vote slightly ahead. Investors wasted no time punishing sterling, which actually underperformed the euro in spite of the ECB dramatic decisions on Thursday. We continue to expect a No vote, though we acknowledge that the likelihood of a surprise Yes vote has risen considerably. Even in the event of a Yes vote, we expect the immediate impact on sterling to be subdued.
In the meantime, the PMI business sentiment indices continue to point to resilient growth. The composite index rose to a new cycle high at 59.3. The recent weakening of the pound can be expected to have a positive impact both on the trade balance and general business confidence, consistent with healthy growth at least in the 2.5-3% range we expect.
In line with our expectations, but against consensus, the ECB launched a new raft of measures at its September meeting. It cut rates by 0.1%, and announced the launch of the long-awaited asset-backed security purchase program, which will also include purchases of covered bonds. Further, it revised down its expectations for inflation and growth and confirmed that it sees risks to the economic outlook “on the downside”, which means it is still in easing mode. President Draghi’s comments at the press conference were extremely downbeat throughout the conference. Although no quantitative easing program was announced, Draghi suggested that some members of the council are actively pushing for it (“some members wanted to do more”).
The main economic release of the week, the final PMI business sentiment report, confirmed the ECB’s downbeat outlook. The levels in Italy were consistent with continued contraction, and those in France with stagnation. The overall drop to 52.5 from 53.8 signals a worrisome loss in momentum. Absent a clear pick up in these leading indicators, we expect that the ECB will launch quantitative easing measures before year end.
The disappointing payroll report provided a soft counterpoint to what had been till then a very strong week of data releases. Job creation in August slowed down to 142,000, from the nearly 240,000 average of the prior three months. More positive signs were seen from unemployment (which reversed the prior month uptick and eased to 6.1%) and the PMI manufacturing survey which surged to 59. Positive numbers from auto sales, construction and trade were all strong, and we reaffirm our forecast of 3-3.5% growth in the third quarter. The Fed is fully on track to end the taper in October and we still pencil in the first hike in rates for the second quarter of 2015.