Over an hour ago, the European Central Bank (ECB) wrapped up its latest policy meeting.
The ECB’s Governing Council, in describing its plans for removing support measures for the economy this year, stuck with using these 3 key words:
“optionality, gradualism, flexibility”.
And if re-arranged, those words offer the acronym: F.O.G. (look out for this again later in the article).
Upon seeing those three words, EURUSD promptly reversed earlier gains and fell back below the 1.090 mark.
Even the words of ECB President Christine Lagarde, who held a press conference after the ECB meeting concluded, couldn’t offer any solace to euro bulls.
EURUSD then fell further to reach its lowest levels since April 2020!.
What are those 3 words even about?
The ECB was talking about its plans about removing support measures for the economy. The reason for doing that is to try and bring down record-high inflation.
Recall that markets had expected the ECB to stick with its plans of buying fewer bonds by next quarter and raising interest rates before 2022 is over.
To be fair, the ECB did say as much.
But the fact that the ECB stuck with those 3 words – optionality, gradualism and flexibility – suggests that the ECB is buying more wiggle room before it raises interest rates that are currently at a record low of negative 0.5%.
In fewer words, the ECB sounded less hawkish than markets had expected.
(To be “hawkish” = to sound aggressive about doing something. In the case for most central banks at present, to be “hawkish” = to want to raise interest rates).
Why does the ECB need to remove those support measures?
The ECB is trying to bring down record-high inflation.
The idea is as follows:
- Higher interest rates = less money supply/lower demand
- Lower demand = companies have to lower their prices to attract customers
- Ideally, this results in lower consumer prices = lower inflation.
How bad is inflation in Europe?
Last month, inflation rose by 7.5% compared to March 2021. That is the sharpest-ever rise in the consumer price index (CPI).
Furthermore, that 7.5% figure is already almost four times more than where the ECB would like the CPI to be – at 2%. And that CPI headline number is set to go even higher over the coming months.
Note that the ECB’s main job is to “keep prices stable in the euro-area”.
But that’s a lot easier said (or written) than done.
Why is inflation soaring?
A big part of it is due to the Russia-Ukraine war.
Oil prices have surged as the world shuns Russian oil, which translates to a shortage of oil around the world.
And as basic economics teaches us, when supply is lower than demand, prices rise.
Note that fuel prices play a massive role in determining the final prices paid by consumers (think about the fuel needed to ship a tiny computer chip from Asia to Europe).
And given how reliant Europe is on Russia for fuel (for example, Germany gets a third of its oil and about half of its natural gas from Russia), further sanctions could mean even scarcer commodities and even higher prices.
READ MORE: Inflation everywhere! What does it mean for markets?
Why does the ECB need more time?
The central bank may not rush to tighten policy/remove support because the Russia-Ukraine war is still raging east of the ECB building in Frankfurt.
Lagarde in her press conference today stated that the ECB remains “very attentive” to uncertainty.
And it’s this uncertainty stemming from the EU’s security crisis that’s F.O.G.-ging up (see what I did there) the economic outlook and making it a lot harder to decide when to raise rates.
But what could go wrong if the ECB raises rates?
The fear is that, if the ECB raises rates too high too soon, it could actually weaken the economy.
And if inflation stays high while economic growth is weak, that leads to “stagflation”.
Already, consumer and investor sentiment in the EU has weakened, while retail sales are losing momentum.
So what if the ECB needs more time?
The greater uncertainty facing the ECB in its quest to return its policy settings back to pre-pandemic levels is putting the ECB further behind other central banks.
Note that these other G10 central banks are already racing forward with their rate hikes:
- Bank of New Zealand – raised its benchmark rate by 125 basis points (1.25%) since Q3 2021
- Bank of Canada – raised its benchmark rate by 75 basis points so far this year
- Bank of England – raised its benchmark rate by 65 basis points since December
- US Federal Reserve – raised rates by 25 basis points in March, perhaps another 50-basis point hike in May
More than 30 central banks around the world have already raised interest rates by 50 basis points in one go so far in 2022.
It’s almost like a race between central banks around the world in the battle against inflation. And the ECB risks getting left behind.
Why is the Euro reacting to a lagging ECB?
Generally, the higher interest rates (and yields) go, the stronger its currency.
The idea is that if an economy is strong enough to withstand higher interest rates (as in, the economy can keep growing despite it becoming more expensive to borrow money), then such conditions could promise healthy returns for overseas investors (as opposed to investing in a relatively weaker economy).
The higher the demand, the stronger the currency of a country with higher interest rates and yields.
Hence, conversely, the further behind the ECB lags its global peers in tightening policy, the weaker the euro.
Yesterday, markets had aggressively priced in a better-than-even chance (54%) that the ECB might even hike rates as early as June.
After today’s meeting, those odds have now fallen to less than 12% = unlikely.
What’s next for the euro?
EURUSD is set to test the immediate support level around the low-1.08 region, having witnessed this double-bottom around 1.0806-09 in recent weeks.
If at its next policy meeting in June, the ECB is still found to be dilly-dallying in the quest to raise interest rates, that could see EURUSD testing the pandemic low around 1.06.
Because by then, the Fed may have already raised its rates by another 50 basis points in May, resulting in a stronger US dollar.
(Remember, stronger US dollar = lower EURUSD).
Overall, the more time the ECB needs to jump on the rate-hike bandwagon, the longer the euro will struggle to recover, keeping the path of least resistance to the downside.
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