Date: 03 Jul 2017

Jens Weidmann, who heads Germany’s Bundesbank and is a member of the European Central Bank’s (ECB) rate-setting body, confirmed Saturday that the ECB is deliberating how to move away from its current ultra-accommodative policy settings. “It will hopefully come and we’re working on that, we’re also discussing it,” Weidmann told an audience at a Bundesbank event. Now traders will know that Weidmann has been a critic of the ECB’s bond buying programme but on this occasion his words may resonate in the currency market following the tone of ECB chief Mario Draghi’s own comments last week in Sintra. But perhaps the real issue for traders to wrestle with is what lies behind recent euro demand. If it has been predicated purely on the prospect of the ECB moving towards removing monetary policy largesse, then the long-euro positioning is by definition vulnerable to comments or below-expectation euro zone economic data prints until such time as the ECB’s stance has been made unequivocally clear. Traders will no doubt be conscious also that much of the foundation of recent improvements in euro zone economic performance has been based on the lower euro giving euro zone exporters a fillip. That benefit is eroded each time the euro rises. Equally, the lower euro helped the euro zone import inflation from outside the currency bloc. A higher euro exerts a disinflationary impulse on imported inflation. Now the ECB knows that but as was made clear by Draghi last week, and picked up by Deutsche Bank, it now sees low inflation in the euro zone as temporary. “The language shift is critical because it “liberates” the euro [and] disinflationary strength in the currency may now matter less for the ECB,” the German bank wrote. Deutsche Bank also argued that there has been a “complete breakdown of EUR/USD with rate differentials suggesting the ECB was losing control of FX anyway” adding that “both these observations are critical because they suggest that the euro can strengthen despite, not because of higher bund yields. In fact, the more the euro appreciates the more ECB tightening will be slowed.” Deutsche

Traders will no doubt be conscious also that much of the foundation of recent improvements in euro zone economic performance has been based on the lower euro giving euro zone exporters a fillip. That benefit is eroded each time the euro rises. Equally, the lower euro helped the euro zone import inflation from outside the currency bloc. A higher euro exerts a disinflationary impulse on imported inflation. Now the ECB knows that but as was made clear by Draghi last week, and picked up by Deutsche Bank, it now sees low inflation in the euro zone as temporary. “The language shift is critical because it “liberates” the euro [and] disinflationary strength in the currency may now matter less for the ECB,” the German bank wrote. Deutsche Bank also argued that there has been a “complete breakdown of EUR/USD with rate differentials suggesting the ECB was losing control of FX anyway” adding that “both these observations are critical because they suggest that the euro can strengthen despite, not because of higher bund yields. In fact, the more the euro appreciates the more ECB tightening will be slowed.” Deutsche Bank therefore concludes that “the key driver of euro strength is not ECB hawkishness but medium-term rebalancing of structural postcrisis underweights in European assets. The ECB may not able to do much about it.” Those kinds of flows would not be so vulnerable to short-term corrections and arguably would increase as such medium-term rebalancing interests could buy into euro weakness. Deutsche Bank has put forward an interesting argument. Traders will have to decide whether they buy into the logic or not.

Written by Neal Kimberley, External Currency Analyst.