Mario Draghi dropped a bombshell in the Q&A part of this week’s ECB press conference. Taken at face value, he has clearly lost patience with the strong Euro and signalled his intent on weakening the currency. To wit, via Ambrose Evans-Pritchard of The Telegraph: “The strengthening of the Euro in the context of low inflation and still low levels of economic activity is a serious concern... the exchange rate will have to be addressed”. Furthermore, the ECB is dissatisfied with the low path for inflation and is “comfortable with acting next month”.
Draghi has essentially pre-committed to either cutting interest rates or embarking on his own version of QE. We believe he will cut interest rates and keep QE for later if lower rates do not weaken the Euro. Draghi is a very cool customer, and he knows that having teed the market up for action, he will absolutely have to deliver next month. No action would risk a severe loss of credibility which would then neuter his forward guidance policy (not that we believe this is a powerful tool in controlling the economy but central bankers do need credibility with the market). The real question now is whether the FX market is ready to help Super Mario weaken the Euro.
Thursday and Friday was an excellent start for the weakening process. The immediate reaction in the market to an unchanged policy and a neutral statement from Draghi was to push to new highs for the current move. It was only in the Q&A that Draghi dropped his “comfortable with acting next month” bombshell, that the market sold off for the rest of the day. Furthermore, there was no respite on Friday – nobody was looking to buy the dip, in fact we would argue the reverse. Our reading of the tea leaves from the chart below is that the Euro has created a classic intra-day failure and reversal and very quickly took out the first level of support which is a bearish set up.
The next chart shows the Euro versus the US Dollar on a weekly basis and again, the pattern looks weak to us and signalling that the Euro has finally turned lower.
In terms of current market positioning and sentiment, the Euro sceptics have been confounded by the strength over the last 18 months and have either given up on the prospect of a Euro decline or even joined the ranks of the bulls. This is the perfect setup for the Euro to decline, i.e. just when everybody has given up on the idea. Measuring market positioning is never easy in FX, but we do think the market is long Euros (certainly the IMM data which is readily available shows the trend following community is long) and these will need to be covered and then the market will need to be short if the Euro is indeed reversing. This process will take weeks not just days.
To conclude, we believe it is time to short the Euro not just against the US Dollar but against a number of currencies. It would appear that this is what the ECB wants (it’s always nice to have the central bank on your side). The Federal Reserve in the US continues to reduce QE and signal rate rises ahead, the technical position has just turned against the Euro and sentiment is conducive to a Euro downtrend. We are wrong if the Euro recovers and moves above 1.40.