Draghi Balancing Act

We look at the President of the European Central Bank's Statement last week

Mario Draghi, President of the Euro Central Bank, last week trod a fine line between providing enough additional stimulus to keep the Euro weak against its competitor currencies and not ignoring his mandate which is to achieve an inflation rate of as close to but not more than 2%.  With the 5 year forward inflation swap at 1.7% (the inflation rate that the markets anticipate in 5 years’ time) one wonders how close Draghi needs to see the inflation rate to 2% before he starts to unwind the massive monetary stimulus programme in the Eurozone.  Although we got the first hint of a taper with purchases falling from €80bn per month to €60bn per month from April 2017 onwards, the programme has been extended for 9 months so the total quantum has been increased.  In addition, the restriction on yields which prevented the ECB from buying securities below a yield of -0.4% has been removed.

As a result, since Trump’s victory, while US Government bond yields have been trending higher, short dated German bond yields have gone even more negative, with the 2 year at -0.79% today.  This makes the yield gap between US and Germany 2 year bond yields 2%.  Looking back over the last 40 years or so, when the yield gap has been above 2% you have had a 2/3rds chance of the US Dollar strengthening against  the Euro.  So in US Dollars, as well as receiving more income, you have been rewarded with a rise in the FX rate. If we also consider the uncertainty surrounding the approaching European elections and the frailty of the Italian banking system, there appear to be good reasons to expect the US Dollar to continue to appreciate against the Euro from here and perhaps challenge parity which is less than 4% away.  

Source: Bloomberg as at 21.12.16

By Jeff Keen

All other data: Thomson Datastream as at 21.12.16

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