Anticipated ECB Action Key Driver of FX

There is one main story today, and that is the anticipation of ECB action. Official comments have encouraged many participants to anticipate rate cuts over asset purchases to be announced when the central bank meets in early June. The economic data, which includes softer Q1 GDP figures, and reduced inflation expectations picked up by the ECB's professional survey took a toll. A report in a Spanish paper claiming the ECB is likely to cut the repo rate 15 bp (to 10 bp) and cut the deposit rate to -25 bp is putting numbers on where expectations were headed.

We had argued about the risks of a negative deposit rate as no major central bank has adopted negative interest rates, including Bank of Japan despite persistent deflation (and a strong currency) and Switzerland with a similar macro profile. When the ECB pushed its deposit rate to zero, banks reduced their use of this facility in favor of another facility at the ECB (current account). However, we are concerned that a negative deposit rate will be either in part or whole be passed on to large bank clients, or the banks will absorb the hit at the same time that they are under strong pressure to strengthen their balance sheets.

Although the Bundesbank's Weidmann indicated yesterday that the German central bank had not agreed to any specific measures, he did seem to acknowledge that there was some risk of deflation. However, other ECB officials like Vice President Constancio continues to deny risk of deflation. To be sure it is this risk and not the disappointing growth numbers that appear to be driving the perceived need for ECB action. This will likely be reflected in the new staff forecasts. Today the ECB published the results of its survey of professionals and the key 2016 (to capture inflation over the medium term) was reduced to 1.5% from 1.7% previously and the 2015 forecast was shaved to 1.3% from 1.4%. The staff forecasts, which are perceived to provide the official rationale for action are likely to be in line with these results.

First quarter growth in the euro area also disappointed. The 0.2% quarter-over-quarter expansion was half the pace the consensus expected. This is the same pace as Q4. However the year-over-year pace accelerated to 0.9% from 0.3%. Germany and Spain did produce small upside surprises (0.8% and 0.4% respectively). However, the Netherlands (-1.4% vs flat expectation), Italy (-0.1% vs 0.2% consensus) and Portugal (-0.7% vs 0.1% consensus) were disappointing. France flat lined and had been expected to show a little positive growth (0.1%).

These developments cut the legs under the euro after yesterday's half-hearted attempt to stabilize. The push below the $1.3675 area is potentially significant. It arguably marks the neck line of a large double top pattern, formed by the mid-March high just below $1.3970 and the high set let week just below $1.40. Roughly speaking this is a three cent pattern that would project a target of around $1.3375. That is a ways off and before that, the euro has some wood to chop. The next initial target is the 200-day moving average, which is found near $1.3625 today. The euro has not traded below this moving average since last September, and even then it was only for a couple of days. The last significant low was recorded last July near $1.2750. The initial retracement of the subsequent advance comes in near $1.3525.

Two countries that appear to be particular sensitive to ECB actions are Denmark and Switzerland. A negative deposit rate by the ECB could weaken the euro against the Danish krone. The Danish central bank, whose monetary policy is driven by the krone's link to the euro, had to raise rates recently to defend it. Rate cuts by the ECB may give it scope to unwind that increase. For Switzerland, the implication may not be as friendly. There is some concern that the SNB will be forced to defend its currency cap. It has not had to spend a centime in recent quarters to enforce it.

In contrast to the disappointing euro area growth, Japan reported stellar growth of 1.5% (quarter-over-quarter) in Q1, which is half again as strong as the market expected (1.0%). Strength was seen in private consumption and capital expenditures, ahead of the retail sales tax increase. Private consumption rose 2% over the quarter, which was in line with expectation.

It was capital expenditures that surprised. It rose 4.9% increase on the quarter, which is more than twice what the consensus expected (~2.1%). Exports were sluggish and energy imports were elevated, and this turned into a 0.3% drag on GDP, a little less than expected. The risk is that the economy, however, contracts in the current quarter and that Q1 growth in effect borrows from at least Q2 and possibly Q3 activity. Separately, perhaps, more important than these elements, the fact that the GDP deflator was not negative (flat year-over-year) for the first time in 18 quarters is more important for the outlook for monetary policy. Many expect the BOJ to expand its asset purchases by July.

For its part, the yen is sidelined. It is largely within yesterday’s range against the dollar, despite the fall in US 10-year Treasury yields to new lows for the year and is little changed on the day. However, unwinding long euro/short yen cross positions has taken a toll, and the cross now is at its lowest level since late February, just ahead of JPY139. A break of that could spur a move toward JPY138.25.