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Euro May Weather a Dovish ECB Amid Policy Divergence Bets

Euro May Weather a Dovish ECB Amid Policy Divergence Bets

(Bloomberg) -- The euro may weather a widely-expected dovish policy statement next week by the European Central Bank.

Investor confidence in the shared currency is the highest in more than a year, option prices show, even as the ECB is widely expected to signal that interest rates could be cut further below zero. While the prospect of policy action as early as next week has pushed up one-week implied volatility in the euro-dollar pair, the measure was still below the past year’s average.

Euro May Weather a Dovish ECB Amid Policy Divergence Bets

The euro is drawing strength mainly from dollar weakness amid expectations that the U.S. Federal Reserve will ease monetary policy more aggressively than the ECB. Recent Fed policy-maker comments have spurred bets that the U.S. central bank may lower its benchmark rate by as much as half a percentage point this month. A similar magnitude of cuts could prove challenging for the ECB, whose deposit rate is already at a record low of minus 40 basis points.

While some analysts think the ECB could act earlier than priced in by markets, that view might be misplaced, according to Danske Bank’s Kristoffer Kjaer Lomholt, given that the ECB is considering deposit rate tiering to soften the side-effects of negative rates on banks.

“A potential tiering system essentially would counter the negative euro impact,” said Kjaer Lomholt, a senior analyst at Danske. “We still forecast euro-dollar to rise to $1.15 in three months on relative monetary policy, where the Federal Reserve eases more aggressively than ECB.”

The euro was around $1.1230 Friday in London, having recovered from this year’s low in May of $1.1107. Six-month risk reversals in euro-dollar were at 32 basis points in favor of call options, the highest since April 2018. A similar-tenor gauge for implied volatility touched its lowest level since 2007 earlier this month. Danske predicts the euro to rise to $1.17 in six to 12 months as global trade tensions eventually ease and there’s a further reversal in positions betting on the euro’s decline.

Euro May Weather a Dovish ECB Amid Policy Divergence Bets

What to Watch

  • The main focus will be the ECB’s policy decision Thursday, after which President Mario Draghi will hold a press conference
  • In the U.K., the ruling Conservative Party will name a new Prime Minister
  • Economic releases in the U.S. include the preliminary readings for Purchasing Managers Index for July, home sales, durable goods orders and the advanced reading for 2Q GDP
  • July preliminary PMIs for Germany, France and overall eurozone; German retail sales and IFO business climate; French and Italian consumer confidence; eurozone M3 money supply for June

To contact the reporter on this story: Anooja Debnath in London at adebnath@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Anil Varma, Neil Chatterjee

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