Easy money, stronger currency?

In the last six months, that anchoring could best be described as tenuous. One-year breakeven inflation swap rates, spot, 1-year, 2-years, and 3-years forward fell steadily in the last year and are now well below mandate, and even 5-year, 5-year forward breakeven inflation, while still above 2%, steadily declined in the past six months (Figure 1).

Thursday’s ECB meeting succeeded in beginning to turn the tide of inflation expectations. Breakeven rates 2- and 3-years forward began to turn higher following the May ECB meeting when the Bank foreshadowed easing at its June meeting. But all forward breakevens turned higher or accelerated in their rise following Thursday’s announcement of a much larger-than-expected expansion of liquidity.

Admittedly, this is based on two days’ reaction, but it appears that the ECB is succeeding towards their goal. We fully expect that success to be sustained, even if it takes additional measures. President Draghi and the ECB have unmistakably articulated an “anything it takes” message with regard to raising inflation back to mandated levels.

The exchange value of the EUR is not a measure of ECB success. Of course a weaker EUR would help the ECB achieve its inflation goal and likely would be welcomed. But in a large economy like the euro area, inflation expectations are far more important in meeting the ECB’s inflation target than the exchange value of the euro.

We expect the ECB’s likely success with inflation expectations also will succeed in driving a trend of EUR weakness. We have repeatedly highlighted the importance of real interest rate differentials in supporting EUR strength. But real interest rates are based on expected, not realized inflation. The ECB’s clear commitment to raise inflation – and demonstrated credibility as evidenced by inflation swaps – is raising inflation expectations, lowering real interest rates. We have high conviction that the EUR will follow suit.

The temporary rebound in the EUR post ECB meeting is puzzling, but does not change our view. Short-term market dynamics are often difficult to explain, but fundamentals always prevail over any reasonable horizon. Note that the EUR is lower versus the USD and on a trade-weighted basis since ECB committed to ease policy at its May meeting.

As to the EUR’s surprising post-meeting rebound last week, both market pricing and anecdotes strongly suggest that FX market participants were long volatility going into Thursday’s ECB meeting, and the rebound may be related to position management. The inversion of the short-term vol curve for EURUSD, measured by the ratio of 1-week to 1-month implied volatility, was at its greatest since the advent of the euro (Figure 2).

Regardless, we remain convinced that the ECB has turned a corner, both in its own commitment and its credibility with markets, to raise inflation. The associated decline in real interest rates should push the EUR lower.