Euro Spanked As ECB cuts Forecasts and Warns of Downside Risks

illustrated by Joe Cummings

The euro has sold off a cent in the immediate reaction to ECB President Draghi's press conference.  A break of $1.11 would target $1.1025, though the target is unlikely to be seen ahead of tomorrow's US employment report.    

There are three key take ways from Draghi's comments.  First, the ECB has raised the ceiling of sovereign bond ownership to 33% from 25%.  This eases a self-imposed constraint on purchases, and will give the ECB more operational flexibility.  

Second, the ECB staff shaved growth forecasts lower. This year's GDP is seen at 1.4%, down from 1.5%.  Growth next year was cut to 1.7% from 1.9% and 2017 GDP was reduced to 1.8% from 2.0%.  

Third, inflation forecasts were cut by a bit more than growth.  CPI this year is expected to rise by 0.1% rather than 0.3% estimated in June.  The 2016 inflation forecast was cut to 1.1% from 1.5%.  The 2017 CPI forecast was trimmed to 1.7% from 2.0%.  

Draghi has, as expected, emphasized that its asset purchases can be adjusted in terms of size and duration as needed.  He notes that downsides risks have increased.  Combining the two points, one is left with the conclusion that further deterioration of conditions or increase in risks would prompt a policy response.  It is part of the process that we suggest will help forge a consensus.  It is revealing that despite the decline in the euro over the past year, Draghi claimed that weaker external demand weighing on growth.  

What some market observers have cited as the safe haven status of the euro appears mistaken.  It did rally amid the recent market turmoil, but this seems largely a reflection of its role as a funding currency.  The short euro position was used to finance (fund) purchases of European equities, bonds, the Chinese yuan, emerging market assets, etc.  In addition, some participants hedged the currency risk of their exposure to euro-denominated assets.  As those trades unwound, the euro strengthened.  Its strengthening was not a result of investors flocking to the euro to escape the carnage, but was a function of reduced euro shorts and short euro hedges.  

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