EUR/USD: ECB may react to growing signs of weakness

  • Euro-zone growth may remain robust, but the engine is slowing down.
  • The ECB may exercise its conditionality and prolong the exit.
  • The EUR/USD may lose more ground on growing divergence.

The euro-zone grew at a pace of 0.4% QoQ in Q1 and also in Q2 2018. Forecasts for the third quarter are positive, and the European Central Bank is cautiously optimistic.

One day before the ECB makes its rate decision and publishes new growth and inflation forecasts, it received a cold reality check. Euro-zone industrial output dropped by 0.8%, below 0.5% that was expected. The relatively small miss in a volatile indicator was ignored by markets, and the EUR/USD continued hugging the 1.1600 level.

However, looking deeper into the data, and the lights begin flashing red. FXStreet expert Joseph Trevisani comments:

The collapse in eurozone industrial production from 5.2% annually in December to -0.1% in July is the steepest and most prolonged in five years and it may well give the ECB second thoughts as it considers the end of its economic support program.

The miss in manufacturing is, therefore, not that new and is becoming a drag. It may have been a result of concerns about global trade, and the situation may be exacerbated if the trade wars escalate. In any case, without the manufacturing motor, mostly coming from the economic locomotive Germany, the economy of the 19-country economic bloc may struggle.

If the malaise in manufacturing continues, it will also weigh on services tied up to it, and it may dampen the growth outlook.

The ECB’s very conditional exit

The ECB is tapering its bond-buying program in October, halving it to €15 billion / month, and ending it altogether in 2019. The Frankfurt-based institution also pledged to keep the interest rate unchanged through the next summer. According to bond markets, there is a high chance of a rate hike in September 2019.

When ECB President Mario Draghi laid out the plans in June, he stressed that the rollout depends on a continuation of the recent trends. This conditionality may come in handy sooner than later. Data such as these may trigger not only lower forecasts but also a pushback in the ECB’s exit plans.

If dark clouds gather in the winter, the ECB may wait beyond the end of the summer of 2019 before raising rates, exercising the conditionality.

While Germany is the country most reliant on exports of industrial goods, its officials are the most inflation-averse ones. Policymakers from the continent’s largest economy have called for the end the QE program as soon as possible. They may also need to make a change of heart.

Most other ECB members, led by President Draghi, are quite dovish. They will not be much convincing to wait even longer with the very cautious exit.

EUR/USD and monetary policy divergence

If the ECB lowers forecasts and follows through with a delay in exiting the very accommodative monetary policy, the common currency will suffer. The ECB is far behind the US Federal Reserve. The Fed began raising rates in December 2015 and has accelerated the pace of increases of late. Contrary to the ECB, the current composition of the FOMC is more hawkish.

If this divergence broadens, the EUR/USD may brace itself for the downside. The 2018 low of 1.1300 may come into play and so will the round number of 1.1000 or levels further down.

The EUR/USD may stabilize if the Fed also changes course by saying it has reached the elusive neutral interest rate and that further tightening is not needed. With mostly upbeat US data of late, a dovish turn by the FOMC is far from being imminent.

Conclusion

All in all, the downturn in the euro zone’s industrial production is more worrying than the high-frequency data suggest and may drag the euro-zone lower. For a meaningful reaction in the EUR/USD, a response by the ECB is needed. That reaction may come sooner rather than later given the ECB’s dovish stance.

More: Triple trade truce unlikely to last, USD may resume the rally


Leave a Reply

Яндекс.Метрика