London Session: Dissecting a less dovish Draghi

The Draghi press conference didn't provide much in the way of direction for euro-based assets, yet EURUSD had one of its most volatile afternoons in days. The pair was 1.3100 when Draghi first started speaking.  By the time he had finished EURUSD was up 70 points. The ECB didn't shift its stance and it didn't sound any more dovish than it did the last time it met so why the big move in the euro? The reason is down to rate differentials. Draghi didn't cause the rate differential between the currency bloc and the US to narrow as some had expected, which is euro positive in the short-term.

In the long-term the ECB's policy stasis is euro negative especially as the sovereign debt crisis continues to rage and growth in Spain may get worse before it gets better. But the market is unlikely to concentrate on that for now.

Here are the main points from today's press conference: 

·         The ECB did not discuss lowering the interest rate at this meeting. The market has perceived this as hawkish, although rates in the Eurozone are already at record euro-era lows...

·         The Bank still expects the Euro-area economy to recover gradually for the rest of this year

·         He said the economic outlook is subject to downside risks (Spain springs to mind)

·         Inflation could remain above 2% for the rest of this year, although modest growth in the Eurozone may cause long-term inflation pressures to remain moderate.

·         The LTRO has helped to stabilise funding conditions in the banking sector.

·         The ECB supports the fiscal consolidation plans currently in place in Europe's periphery

·         The ECB's primary objective remains price stability over the medium-term

·         Individual governments need to address growth divergences in the region.

Draghi didn't diverge from the ECB's mandate of maintaining price stability in his speech today. As expected he didn't hint that the Bank would re-start any of its special measures like the SMP programme to help ease concerns in the struggling periphery. His message was clear: the ECB doesn't have the tools or the mandate to sort out the deep-seated imbalances and growth problems that are plaguing Europe right now - that has to happen at the government level.

More surprising was that he didn't use the press conference to discuss the Growth Compact that he suggested at a speech to the European Parliament last week, although he did sound concerned about the deteriorating growth picture.

Right now the ECB seems to be happy to remain on hold as Spanish and Italian bond yields have remained steady, albeit at high levels, and banks don't seem to be at risk of a credit crunch after the two LTRO auctions.

So what could spur the Bank to action and what could it do?

We believe the ECB will only act if volatility spikes higher as it did in November 2011. However, what it could do in the event of elevated vol levels is harder to determine. LTRO is controversial and an interest rate cut may not make much difference to struggling peripheral economies because 1, real rates are already negative and 2, demand for credit is sluggish anyway. The Bank could re-activate the SMP programme, which has helped relieve pressure on bond yields at a moderate expense for the Bank in the past. However, it does contravene the Bank's rule that it can't finance individual governments, and the SMP is opposed by Germany. Thus it is hard to see what the ECB can do if it doesn't change its mandate.

What now for the euro?

A hawkish ECB is short-term euro positive, but long-term euro-negative as the ECB essentially does not have the tools to address this crisis, which only adds to market uncertainty. After today's press conference the rating agency Fitch said that risks are growing that the Eurozone won't muddle through this crisis and added measures are needed to resolve it. The lack of action from the ECB probably means that we are back to range-trading for EURUSD. 1.3100- 1.3330 are the immediate parameters to be aware of for now. We have said before that if vols are stable because the markets expect the ECB to sort out any problems then they could be disappointed. Thus the lack of action from the ECB could eventually cause the euro to break out of this range to the downside.

For those with no appetite for range trading, EURGBP could still grind lower to 0.80, although we need to get the BOE's Inflation Report on 16th May to determine the medium-term direction for this pair.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957  | e: kbrooks@forex.com| w: www.forex.com/uk

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