The increasing importance to the forex market of Draghi’s musings was evident as the euro sold off sharply at his mere mention of the single currency’s strength after the ECB’s policy meeting on Thursday.
Let’s be clear, it was no frontal assault in the context of the global currency wars.
Draghi was at pains not to be drawn into open conflict, maintaining the recent appreciation was a sign of a return in confidence in the euro and that the exchange rate was not a policy target.
As if to emphasize the fact he was not prepared to engage in the currency war game, which was kicked off last autumn by Japanese policymakers eager to weaken the yen, Draghi reiterated the G20 mantra about market-driven exchange rates.
“Exchange rates should reflect fundamentals and, by and large, both the nominal and the real exchange rates [of the euro] are about their long-term averages,” he said.
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Still, if Draghi is no currency warrior, this year he has acted like a general in an old nursery rhyme.
Like the grand old Duke of York, he marched euro bulls up to the top of the hill in January, citing positive contagion effects in the eurozone, and then marched them down again on Thursday by weakening the euro through the only means at his disposal: managing interest rate expectations lower.
By linking euro strength with the possible need for ECB staff inflation forecasts to be revised lower next month, he pushed rates from their recent highs, narrowing rate spreads against other currencies and sending the euro sliding.
Draghi did not, of course, have to mention rate cuts directly – he did not need to. Eurozone inflation fell to 2% in January and is expected to fall below target in the months ahead. Furthermore, only the ECB, with rates at 0.75%, has room for further cuts among G4 central banks, giving the euro room to fall against the dollar, yen and sterling.
The question is whether the ECB, by implicitly threatening interest rate “intervention”, might have managed to put a top in place as far as the appreciation of the euro is concerned.
As Kathleen Brooks, research director at Forex.com, notes, Draghi mentioned that the 10-year moving average for EURUSD is $1.3450, around current levels.
“Although the ECB isn’t targeting this level, it suggests it may be uncomfortable for the bank if EURUSD rises towards $1.40,” she says.
Ian Stannard, head of European FX strategy at Morgan Stanley, says the fact the ECB recognized the strength of the euro in its statement after its policy meeting – usually currency matters are addressed in the press conference – signals a change in policy at the central bank.
“Although the language used to describe the euro is in the context of being a downside risk to inflation, and hence may appear moderate, we would suggest the fact that the reference has been added is important, with markets now likely to view the level of the euro as a more formal part of the ECB’s monetary framework,” he says.
For his part, Stannard believes the pullback in the euro might prove temporary, however.
That is because he believes the euro rally has been driven by portfolio flows back into the eurozone, as the ECB’s OMT programme reduced the prospect of a eurozone break and helped ease the region’s sovereign debt crisis – something that has not changed after the ECB’s musings on currency strength.
That would appear to be the challenge facing the ECB: whether the euro can break its correlation with improving sentiment towards the eurozone financial system.
If not, and if sentiment continues to improve, Draghi might find himself pontificating more and more on the exchange rate.