What next for the euro after yesterday’s dovish ECB shift?

A few weeks ago, following a conclusive strategy review, the ECB announced a new inflation target. The ECB said that it will now pursue a 2.0% inflation target, instead of its prior “below, but close to, 2.0%” target. At yesterday’s rate decision, where the bank left all of its policy settings on hold as expected (deposit rate at -0.5% and the pace of monthly QE purchases unchanged), it unveiled what this new inflation target means for its interest rate guidance. The ECB has now signalled to markets that 1) it wants to see inflation actually move back above 2.0% and 2) it wants to forecast inflation of robustly above 2.0% for the duration of its forecast horizon before it embarks on any rate hikes. The market reaction to the ECB’s new guidance for the most part was dovish; Eurozone bond yields mostly moved lower, with the biggest drop seen in Italian yields (Italy is seen as a disproportionate beneficiary of dovish ECB policy), and major European equity bourses have continued their recovery from the drop seen earlier in the week and are mostly back close to record highs. The EURO is also languishing just above multi-month lows in the mid-1.1700s. A dovish reaction is unsurprising given the ECB has essentially sent the signal that, given its new inflation target, it will take longer to fulfil the conditions required for the bank to start hiking rates, meaning accommodative policy for longer.

ING take the view that one key motivation for the ECB’s strategy review was to weaken the euro. “We’re sure the ECB looked in awe at the Fed’s Average Inflation Targeting strategy that the Fed adopted and its impact on the dollar”, the banks say. The bank notes that the key reason why the Fed was able to drive the dollar lower last year after its own strategy review was that is managed to provide a meaningful lift to inflation expectations, which pushed real yields lower. The bank warns that the ECB might not be able to generate as potent a lift to inflation expectations, which in turn would be expected to put less downwards pressure on Eurozone real yields and perhaps also the euro. This is because while the Fed shifted its mandate on inflation to “average inflation targeting” (which means after a period of lower than target inflation, as has been the case in over the last decade), the Fed will pursue higher than target inflation), the ECB has only shifted to a symmetric 2.0% inflation target. This is the same as the Fed’s old inflation stance and signifies that the ECB will not be targeting inflation of above 2.0% for a prolonged period to make up for lower inflation in the past. In other words, it’s a less dovish inflation mandate. However, net, ING and other banks/analysts seem to agree that the updated guidance on interest rates held reaffirm the fact that any meaningful monetary policy tightening from the ECB remains a very long way away and the bank continues to sit amongst the most dovish banks in the G10 (alongside the SNB and BoJ). That means the euro is likely to remain a popular “funding currency”, i.e. market participants will continue to want to borrow in euros thanks to the negative interest rate and then lend that money in parts of the world (like emerging markets) where interest rates are much higher. As concluded by MUFG, “the updated guidance from the ECB is consistent with EUR being a laggard in the G10 space as global recovery proceeds”.

There is one important source of uncertainty that must be cleared before FX strategists can confidently update their euro forecasts, however. We still don’t know what the outcome of the ECB’s latest strategy review (that led to the tweaked inflation target) means for its various bond buying programmes. ECB President Lagarde had hinted after the ECB unveiled its strategy review a few weeks ago that we would be getting updated guidance on the ECB’s QE policy once the Pandemic Emergency Purchase Programme (called the PEPP) expires in March 2022. One would have assumed that the ECB might opt to beef up its Asset Purchase Programme (APP), which has existed since prior to the onset of the pandemic, to “smooth” out the pace of the reduction of monthly purchases from next March. However, in recent weeks, ECB sources suggested that there is division on the ECB’s governing council with regards to its QE guidance. It looks as though we will likely have to wait for September to get this updated guidance on QE. This will prove a big test about how serious the ECB is about hitting its new inflation target; if they fail to provide a meaningful boost to the APP to make up for the end of the PEPP after March, this will send a signal to the market that the ECB is “all talk” with regards to its inflation mandate. Any weakness in the euro, weakness in bond yields, increase in inflation expectations and easing of financial conditions that might have occurred between now (when the new interest rate guidance was announced) and September could well be unwound in such a scenario. Alternatively, if the ECB does live up to market expectations, we could see a continuation of euro weakness beyond the September meeting.