EURUSD slips on a dovish hike by ECB; Dow, Dax surged

On Thursday, all focus was on the ECB’s monetary policy decision. ECB surprised the market to some extent and unexpectedly hiked all key policy rates by +0.25%; i.e. reference interest rates on the main refinancing operations (MRO-interbank rate) to +4.50%; interest rates on the marginal lending facility (MLF-repo rate) to +4.75%, and interest rate on deposit facility (DRF-reverse repo) to +4.00%, all are at 22-years high (since Oct’2008) after 10th   consecutive rate hikes since July’22, cumulating +450 bps.

ECB said: “Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.”

But ECB President Lagarde also acknowledged: “I am not saying we are at peak rates--- We are not saying that we're now at the peak, we can't say that now”.

In its Sep’23 macroeconomic projections, ECB staff projected core HICP inflation for 2023 at +5.1% on average for 2023, unchanged from June’23 projection, and projected slightly lower average core HICP inflation for 2024 (+2.9% vs. 3.0%) and 2025 (+2.2% vs 2.3%). But the ECB has significantly reduced its real GDP growth projections for 2024; now anticipating the Euro Area economy to expand by 0.7% in 2023, 1.0% in 2024, and 1.5% in 2025 against earlier projections of +0.9%, +1.5% and +1.6%. Overall, the ECB has painted an economic picture like stagflation for 2024 amid lower economic growth of around +1.0%, a higher unemployment rate of around +6.7% and elevated core inflation of around +2.9%. ECB also projected core inflation around +2.0% targets by Dec’25 or even after that in early 2026.

Also, the ECB indicated that after the September hike, the policy rate has reached a restrictive zone and thus further rate hikes may not be needed unless there are some nasty surprises over core inflation data for the next few months. Although the ECB kept the door open for a further hike (if needed) and surprised the market in general, it was not a bolt from the blue as some ECB policymakers gave a last-minute hint about the dovish hike a few days ago after months of not so hawkish jawboning about a possible September hike. But the market was pricing for the last hike for CY23 in October, in line with Fed as the latter is posed for a pause on 20th September, but a hike on 1st November. Thus despite an ‘unexpected’ ECB hike, EURUSD stumbled as the overall tone was on the dovish side (almost done with tightening) along with subdued economic growth projections (stagnation).

Full Text of ECB statement: Monetary policy decisions: 14th September’2023

“Inflation continues to decline but is still expected to remain too high for too long. The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. In order to reinforce progress towards its target, the Governing Council today decided to raise the three key ECB interest rates by 25 basis points.

The rate increase today reflects the Governing Council’s assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. The September ECB staff macroeconomic projections for the euro area see average inflation at 5.6% in 2023, 3.2% in 2024, and 2.1% in 2025. This is an upward revision for 2023 and 2024 and a downward revision for 2025. The upward revision for 2023 and 2024 mainly reflects a higher path for energy prices.

Underlying price pressures remain high, even though most indicators have started to ease. ECB staffs have slightly revised down the projected path for inflation excluding energy and food, to an average of 5.1% in 2023, 2.9% in 2024, and 2.2% in 2025.

The Governing Council’s past interest rate increases continue to be transmitted forcefully. Financing conditions have tightened further and are increasingly dampening demand, which is an important factor in bringing inflation back to target. With the increasing impact of this tightening on domestic demand and the weakening international trade environment- ECB staffs have lowered their economic growth projections significantly. They now expect the euro area economy to expand by 0.7% in 2023, 1.0% in 2024 and 1.5% in 2025.

Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target. The Governing Council’s future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary. The Governing Council will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, the Governing Council’s interest rate decisions will be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.

Key ECB interest rates

The Governing Council decided to raise the three key ECB interest rates by 25 basis points. Accordingly, the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will be increased to 4.50%, 4.75% and 4.00% respectively, with effect from 20 September 2023.

Asset purchase programme (APP) and pandemic emergency purchase programme (PEPP)

The APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities. As concerns the PEPP, the Governing Council intends to reinvest the principal payments from maturing securities purchased under the programme until at least the end of 2024. In any case, the future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance. The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.

Refinancing operations

As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations and their ongoing repayment are contributing to its monetary policy stance.

The Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its 2% target over the medium term and to preserve the smooth functioning of monetary policy transmission. Moreover, the Transmission Protection Instrument is available to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries, thus allowing the Governing Council to more effectively deliver on its price stability mandate.”

Text of the opening statement by ECB President Lagarde: 14th September’2023

“Inflation continues to decline but is still expected to remain too high for too long. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. In order to reinforce progress towards our target, the Governing Council today decided to raise the three key ECB interest rates by 25 basis points.

The rate increase today reflects our assessment of the inflation outlook in light of the incoming economic and financial data; the dynamics of underlying inflation, and the strength of monetary policy transmission. The September ECB staff macroeconomic projections for the euro area see average inflation at 5.6 percent in 2023, 3.2 percent in 2024 and 2.1 percent in 2025. This is an upward revision for 2023 and 2024 and a downward revision for 2025. The upward revision for 2023 and 2024 mainly reflects a higher path for energy prices.

Underlying price pressures remain high, even though most indicators have started to ease. ECB staffs have slightly revised down the projected path for inflation excluding energy and food, to an average of 5.1 percent in 2023, 2.9 percent in 2024 and 2.2 percent in 2025.

Our past interest rate increases continue to be transmitted forcefully. Financing conditions have tightened further and are increasingly dampening demand, which is an important factor in bringing inflation back to target. With the increasing impact of our tightening on domestic demand and the weakening international trade environment, ECB staffs have lowered their economic growth projections significantly. They now expect the euro area economy to expand by 0.7 percent in 2023, 1.0 percent in 2024 and 1.5 percent in 2025.

Based on our current assessment, we consider that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target. Our future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary. We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.

The decisions taken today are set out in a press release available on our website. I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions.

Economic activity

The economy is likely to remain subdued in the coming months. It broadly stagnated over the first half of the year, and recent indicators suggest it has also been weak in the third quarter. Lower demand for the euro area’s exports and the impact of tight financing conditions are dampening growth, including through lower residential and business investment. The services sector, which had so far been resilient, is now also weakening. Over time, economic momentum should pick up, as real incomes are expected to rise, supported by falling inflation, rising wages, and a strong labor market, and this will underpin consumer spending.

The labour market has so far remained resilient despite the slowing economy. The unemployment rate stayed at its historical low of 6.4 percent in July. While employment grew by 0.2 percent in the second quarter, momentum is slowing. The services sector, which has been a major driver of employment growth since mid-2022, is now also creating fewer jobs.

As the energy crisis fades, governments should continue to roll back the related support measures. This is essential to avoid driving up medium-term inflationary pressures, which would otherwise call for an even stronger monetary policy response. Fiscal policies should be designed to make our economy more productive and to gradually bring down high public debt. Policies to enhance the euro area’s supply capacity – which would be supported by the full implementation of the Next Generation EU programme – can help reduce price pressures in the medium term, while supporting the green transition. The reform of the EU’s economic governance framework should be concluded before the end of this year and progress towards Capital Markets Union should be accelerated.

Inflation

Inflation declined to 5.3 percent in July but remained at that level in August, according to Eurostat’s flash estimate. Its decline was interrupted because energy prices rose compared with July. Food price inflation has come down from its peak in March but was still almost 10 percent in August. In the coming months, the sharp price increases recorded in the autumn of 2022 will drop out of the yearly rates, thus pulling inflation down.

Inflation excluding energy and food fell to 5.3 percent in August, from 5.5 percent in July. Goods inflation declined to 4.8 percent in August, from 5.0 percent in July and 5.5 percent in June, owing to better supply conditions, previous drops in energy prices, easing price pressures in the earlier stages of the production chain, and weaker demand. Services inflation edged down to 5.5 percent but was still kept up by strong spending on holidays and travel and by the high growth of wages.

The annual growth rate of compensation per employee remained constant at 5.5 percent in the second quarter of the year. The contribution of labor costs to annual domestic inflation increased in the second quarter, in part owing to weaker productivity, while the contribution of profits fell for the first time since early 2022.

Most measures of underlying inflation are starting to fall as demand and supply have become more aligned and the contribution of past energy price increases is fading out. At the same time, domestic price pressures remain strong. Most measures of longer-term inflation expectations currently stand at around 2 percent. But some indicators have increased and need to be monitored closely.

Risk assessment

The risks to economic growth are tilted to the downside. Growth could be slower if the effects of monetary policy are more forceful than expected, or if the world economy weakens, for instance owing to a further slowdown in China. Conversely, growth could be higher than projected if the strong labour market, rising real incomes, and receding uncertainty mean that people and businesses become more confident and spend more.

Upside risks to inflation include potential renewed upward pressures on the costs of energy and food. Adverse weather conditions and the unfolding climate crisis more broadly, could push food prices up by more than expected. A lasting rise in inflation expectations above our target, or higher than anticipated increases in wages or profit margins, could also drive inflation higher, including over the medium term. By contrast, weaker demand – for example due to a stronger transmission of monetary policy or a worsening of the economic environment outside the euro area – would lead to lower price pressures, especially over the medium term.

Financial and monetary conditions

Our monetary policy tightening continues to be transmitted strongly to broader financing conditions. Funding has again become more expensive for banks, as savers are replacing overnight deposits with time deposits that pay more interest and the ECB’s targeted longer-term refinancing operations are being phased out. Average lending rates for business loans and mortgages continued to increase in July, to 4.9 percent and 3.8 percent respectively.

Credit dynamics have weakened further. Loans to firms grew at an annual rate of 2.2 percent in July, down from 3.0 percent in June. Loans to households also grew less strongly, by 1.3 percent, after 1.7 percent in June. In annualized terms based on the last three months of data, household loans declined by 0.8 percent, which is the strongest contraction since the start of the euro.

Amid weak lending and the reduction in the Eurosystem balance sheet, the annual growth rate of M3 fell from 0.6 percent in June to an all-time low of -0.4 percent in July. In annualized terms over the past three months, M3 contracted by 1.5 per cent.

Conclusion

Inflation continues to decline but is still expected to remain too high for too long. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. In order to reinforce progress towards our target, the Governing Council today decided to raise the three key ECB interest rates by 25 basis points.

Based on our current assessment, we consider that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target.

Our future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary. We will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction.

In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission.

We are now ready to take your questions.”

Highlights of Lagarde’s comments during Q&A (Presser): 14th September’2023

·         Inflation is still seen as too high for too long

·         Governments should roll back energy support measures (subsidies/grants)

·         The labour market is resilient

·         Economic momentum should pick up as real incomes rise (amid falling inflation and rising wages)

·         Services are weakening

·         Recent indicators suggest a weak Q3

·         Economic growth to be subdued

·         Calibrated Fiscal policies should make economies more productive, ensuring lower public debt

·         In the coming months, inflation will fall

·         Domestic price pressures remain strong

·         The contribution of profits to inflation fell

·         Some members didn't draw the same conclusions. Some governors would have preferred to pause

·         Rates at the current level will help deliver 2%

·         The ECB is ready to adjust all instruments as needed

·         Rates will remain at sufficiently restrictive levels for as long as necessary

·         Credit dynamics have weakened, and rates have risen

·         Tightening continues to be transmitted strongly

·         Weaker demand is a downside risk to inflation

·         Energy and food are upside risks to inflation

·         Some long-term inflation indicators/expectations are elevated and need to be monitored closely

·         Risks to growth are tilted to the downside

·         A solid majority of ECB members agreed with the decision, but it was not unanimous

·         PEPP is the first line of defense for transmission

·         We did not discuss APP outright sales (QT)

·         We did not discuss the PEPP Programme and Reinvestments

·         Growth to pick up again in 2024, downgrade due to carry-over

·         We didn't discuss what long enough means when it comes to holding rates

·         Focus is expected to move toward the duration

·         I am not saying we are at peak rates

·         Some governors would have preferred to pause and wait on more data

·         Central bank losses don't impact policy decisions

·         Policy transmission to financing conditions is faster than in previous cycles

·         ECB not at the target in 2025 on headline inflation

·         ECB's de Guindos: We have found some links between commercial real estate and mutual funds

·         We need to be attentive to Chinese slowdown and oil prices

·         ECB forecasts assume an exchange rate of $1.09 in 2023, 2024, and 2025

·         ECB forecasts assume a 2023 oil price of $82.70/barrel on average

·         We are not saying that we're now at the peak, we can't say that now

Overall, the odds of an ECB rate hike was around 65% before the event and that comes after a report earlier this week suggested that the ECB will bump up its inflation projections, building the case to communicate one last rate hike on 14th September. Thus the ‘unexpected’ ECB rate hike was not unexpected for those, who follow the ECB closely.

Conclusions:

ECB President Lagarde almost confirmed a pause/pivot after the September hike, but didn’t rule out at least another +25 bps hike in the rest of 2023; there may be another +25 bps hike on 14th December if the Fed goes for a similar hike on 1st November and Eurozone core inflation remains elevated & sticky.

Europe/EU is the real victim of the Russia-Ukraine war as it’s an import-oriented economy for both fuel and food, especially of Russian origin. Euro Area economy may be now in a stagflation-like situation (lower/negative economic growth and higher inflation). Apart from supply chain disruptions, Eurozone core inflation is also boosted by wage growth, pent-up demand, especially for services, and increasing pricing power of producers.

Looking at the trend, contrary to the U.S., core CPI in the Eurozone increased from around +2.3% to +5.3% since Jan’22 despite ECB rate hikes. EU is the biggest loser of the lingering Russia-Ukraine/NATO war/proxy war as it’s a net importer of both food and fuel coupled with other commodities and a weaker EUR.

As per Taylor’s rule, for the Eurozone:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%

Here for EU /ECB

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= Estimated average core inflation=5.5% (for 2023)

If average core inflation in the Eurozone remains around +5.5% in the next few months despite financial / lending/monetary tightening, then the ECB has no option but to match its repo rate (MLF) to around +5.50% instead of +4.50%; i.e. ECB has to keep the terminal rate around 5.50% also in line with Fed. The repo rate of the ECB is now at +4.75% against the Fed’s +5.50%. As the ECB may never match the Fed, the ECB may hike at least another +25 bps for a repo rate at +5.00% against the Fed’s +5.75% expected by Dec’23.

The repo rate of the ECB is now at +4.75% against the Fed’s +5.50% and expected +5.75% by Dec’23. Growing real policy divergence between the Fed and ECB along with a stagflation-like scenario in the EU may keep EURUSD lower in the coming days, causing more imported inflation as the EU depends on both fuel and food imports.

Market wrap:

On Thursday, U.S. and European stock markets surged on the ECB pivot boost as the ECB may have done with tightening and may also start cutting after Q1CY24 (as per market perceptions). But Wall Street Futures were also briefly undercut by hotter than expected PPI, retail sales and softer than expected jobless claims, which may keep the Fed on a hawkish hold stance on 20th September. Subsequently, Gold stumbled to almost 1900 from 1910, but later also recovered to around 1913; with USD hovering around a recent high.

Bottom line:

Technical trading levels: EURUSD

Whatever the narrative, technically EURUSD (1.06400) now has to sustain above 1.06200-1.06000 for a recovery to 1.07800-1.09500; otherwise sustaining below 1.06000, may further fall to around 1.05000-1.04800/300 in the coming days.