Draghi talks down euro but action still in doubt

Euro posts its biggest daily decline in three weeks as ECB president Draghi made his strongest verbal intervention against euro appreciation so far, noting the ECB consensus about dissatisfaction with inflation and his comfortable stance to act at the June meeting, but not before seeing the staff projections on growth and inflation.

It remains to be seen whether Draghi’s remarks are a means to stabilize the rising euro in order to gain time until the next CPI figures, or are indeed a market signal aimed at alerting the next cut in interest rates.

We suspect it’s a case of the former. The ECB has more reasons to stick to its waiting game, while simultaneously discreetly talking down the currency by acknowledging its role in dampening inflation, rather than referring to the pace of its rise or to negative impact on corporate margins. In the event that CPI falls below 0.5% and remains below it by June, then ECB will likely to end up slashing rates by 10 bps in its refinancing rate. Persistent disinflationary worries into September would prompt a conditions-based LTRO3. Yet, we expect Eurozone inflation to stabilize by summer-end –as indicated by the higher core CPI of 1.0%) and keep the ECB from acting.

Getting real on yields

Any euro declines remain temporary, especially against USD as real yield differentials (2-year yields minus inflation) continue to place EUR above USD thanks to higher US inflation (1.2% vs Eurozone’s 0.7%) remaining accompanied by an insufficient yield differential (Germany’s 0.12% vs. US’ 0.39%). We see euro extending declines towards 1.3720-00 before the Fed’s yield realities impose a fresh cap on the dollar and provide support to the single currency. These real yield differentials are the very dynamic behind GBP’s outperformance of the last 9 months. In the case of the EUR-USD yield/inflation differential, the gap has begun to shrink from where it stood in early March. Learning from the surprise ECB rate in November, when the decision triggered a hasty 2-day decline in EURUSD before subsequent stabilisation, Draghi today opted for managing of expectations for the June meeting, which could prove more effective in containing the single currency.

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