Euro falls hard as focus returns to ECB and Fed policy divergence; emerging market currencies rally

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24 October 2016

Written by
Enrique Díaz-Álvarez

Chief Risk Officer at Ebury. Committed to mitigating FX risk through tailored strategies, detailed market insight, and FXFC forecasting for Bloomberg.

Diverging fundamentals and, more specifically, interest rates, are reclaiming the driving seat in currency markets.

A
n anodyne ECB meeting served to remind investors that there is no prospect of a tightening of policy in the foreseeable future, while the Federal Reserve gets ready to hike rates before year end.

This realisation brought the Euro towards the lower end of the 2016 range. Meanwhile, Sterling built on its recent stabilisation and even managed a timid rebound against the US Dollar and a solid rally against the Euro.

The stars of last week were without doubt emerging market currencies. The Brazilian Real, Mexican Peso and South African Rand all rose between 1-3% against major G10 currencies. We expect these currencies to continue to outperform the Euro and Sterling, on the back of stable inflation and high real rates that attract investor inflows.

Major currencies in detail:

GBP

A continued pick up in inflation and a labour report that did not show this inflation passing through to wages were the main economic news out of the UK last week.

However, currency markets remain squarely focused on politics and particularly the prospect of a post-Brexit agreement that maintains UK access to the common market.

Bank of England Governor Carney will testify at the House of Lords Economic Affairs Committee on Tuesday, then Brexit Minister David Jones does so on Wednesday. Markets will be looking for any softening of the Government’s rhetoric during this latter event, which could provided further fuel for the modest Sterling rebound.

EUR

There were few takeaways from last week’s ECB meeting. Tapering bond purchases after the current programme expires in March 2017 was not even discussed and President Draghi deflected all substantive questions to the December meeting.

This week we will see key PMI business confidence reports on Monday. No change is expected, but even a small drop in the composite index would mark the third such consecutive drop in as many months and would help put to bed any concerns over the ECB tapering its economic stimulus.

Positive developments in the Eurozone periphery over the weekend included the increased likelihood of Spain forming a Government and Portugal’s success in maintaining an investment grade rating from DBRS. However, this had little impact on FX markets and provides further evidence that investors are fully focused on policy divergence across the Atlantic.

USD

Trump’s dismal performance in the third and final debate seems to have sealed the fate for his candidacy, as news over the weekend suggested that even typically safe Republican states, like Texas, are up for grabs.

Focus is now shifting back to economic news. This Friday we will see the first reading of third-quarter US economic growth. We expect to see both growth and labour costs growing in a solid 2-2.5% range, which is just what the Federal Reserve needs to hike rates at either the November or the December meeting. Therefore, we are increasingly comfortable with our call for a broadly stronger US Dollar over the next few months.

Technical Analysis

EUR/USD

EUR/USD fell to a four month low after breaching the key 1.0945 support level following the ECB meeting. The pair looks to be heading towards March lows, with the next support level at 1.082.

After the pair breached an ascending trend support (1.1075) it confirmed a head and shoulders formation, denoting the possibility of a further move downwards. Technicals remain neutral although have turned slightly more bearish.

GBP/USD

GBP/USD has extended is downtrend after breaching the Brexit lows following the ‘flash crash’. The next support level is 1.214, with a rebound in Sterling likely to be capped by the 1.24/1.247 resistance level. Technicals remain neutral although have turned slightly more bullish.

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