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Helping Draghi Talk The Euro Down

Courtesy of ZeroHedge. View original post here.

By Steven Englander, Head of Research and Strategy at Rafiki Capital

Helping Draghi talk the euro down

This is last minute, but the ECB needs our help and we won't falter. They clearly do not like a strong euro, do not want to say outright that it will change their policy, but want to convey enough concern to prevent long EUR from being a one-way trade and hopefully get it lower.

What can ECB President Draghi say on Thursday? Keep in mind that at the last press conference he essentially ignored the euro and it ended the day up  1 1/4% versus where it was before the press conference and kept on going.  He was more successful ignoring it at Jackson Hole — the euro was up only 1/2% from the beginning of his talk to the end. As a crude estimate, silence at crucial moments has pushed it up a minimum of 1.75%.

Pushing down the inflation forecast a bit and expecting everyone to get the message  won't work. A reduction in 2018 inflation of 0.1-0.2% is universally expected. Also forecasts are like scarecrows — they work for a day or two and then the birds use them to rest … or worse. However much central banks want you to be influenced by their forecasts, no one goes to jail or loses a job for making a conveniently wrong forecast at a central bank, so investors recognize the temptation for central banks to use forecasts to push market pricing in the direction they want.

The ECB's other problem is that they actually want to taper and probably think EUR strength is a second order issue both for inflation and activity, but they certainly don't want to say that.  Ideally they could taper with a falling euro, so there would be no political pressure from exporters, but that is not esy to achieve. The Germans and others have long thought that balance sheet expansion is misguided. No matter what you say about your intentions, if you can borrow for free — or better – you may be tempted to borrow just a wee little bit more. The activity, inflation and credit creation justifications for asset purchases that existed when they were put in place and expanded do not exist now. If the Fed is worried that low rates means they won't have enough firepower at the next downturn, the ECB  has the same problem cubed. So just assume that tapering is in the cards.

Where it gets difficult is that most investors expect some sort of effort at talking down the euro. It is not enough to say 'we still need a lot of stimulus' or  'we target inflation and the euro affects our inflation forecast'. Such formulations are much too generic.  However the ECB does have an advantage that it is not hard to do better than saying nothing, and takes a bit of effort to do worse.

We have two suggestions below but would appreciate views on:

  1. Will either of these suggestions be enough? and
  2. Is there a better formulation?

Keep in mind that it must be non-committal, but sound aggressive and threatening.

Our two candidates:

1) We will announce changes in the asset purchase program at the next couple of meetings. We are mindful that economic conditions have improved but any factor that alters the economic or inflation outlook  and will affect our policy actions. We all agree on the need for a substantial amount of ongoing stimulus and will make sure our policy stance reflects this need and pushes back against unwanted tightening forces.

or more directly …

2) Currency strength can undermine the return to our inflation target and we will be watching it closely and responding appropriately to make sure it does not endanger our progress.

I think 1) will be enough to generate some EUR downside (maybe 0.5%), but 2) would be much more effective because it is hard to miss the language. They can certainly go as far as 1) but 2) is a much more aggressive formulation (1% or more).

Even 2) is not objectionable from a G20 perspective – it doesn't say you are targeting the exchange rate – it says in a brutal sort of way that you are making sure the exchange rate does not endanger your targets. On the edge but not over a red line.

Personally, I think that EUR strength worries even the hawks, not enough to stop them from tapering, but enough to get their attention. In the past the ECB and Draghi in particular have been able to find formulations that convey their message to the market and I  expect they will succeed again. 

But both they and I would appreciate your judgment on how aggressive they have to be and what is the optimal formulation.


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