Hopes run high ahead of major central bank decisions

Expectations are running high that central bankers will deliver on further policy steps at the Federal Reserve, European Central Bank and Bank of England meetings this week. Indeed, following strong hints by ECB President Draghi last week, which provoked a rally in global markets, there are high hopes that the ECB restarts its bond buying programme.

Opposition by Germany’s Bundesbank could result in disappointment, however. A meeting today between Draghi and Bundesbank president Weidmann will shed further light on the issue. Also on the table is the potential for the ESM bailout fund to be given a banking licence though this seems unlikely any time soon. Given the rally in risk assets at the end of last week, any lack of action by policy makers this week will provoke significant disappointment.

Similarly a run of weaker US and UK data has led to growing hopes that the Fed and BoE will also ease policy further on Wednesday and Thursday, respectively. While recent press speculation suggests that the Fed is edging closer to further balance sheet expansion the Fed FOMC may want to wait for further news on the economic front before embarking on more quantitative easing.

Meanwhile, the BoE appears to be edging towards further easing too, but rather than more QE a rate cut is looking like the preferred option. I suspect that such action at this week’s monetary policy committee (MPC) meeting is unlikely, however. Adding to the drama of this week’s events is the US July jobs report at the end of this week and yet another lacklustre report is expected, with consensus forecasts for a 100k increase in jobs.

Currency markets are likely to settle into ranges ahead of the key events above. The USD lost a fair bit of ground over recent sessions but further direction will await the ECB and Fed meetings. EUR/USD looks firmly settled above support around 1.2241 but upside traction will be limited until there is further clarification from the ECB. I suspect that last week’s short squeeze has run its course, with a further drop in peripheral Eurozone bond yields required to drive the EUR higher.

Asian currencies look well supported in the near term ahead of the major policy decisions. The SGD and KRW have led gains over the past week and their high degree of sensitivity to risk suggests that they should continue to outperform. The INR has also edged higher on the back of firming risk appetite but much will depend on the outcome of the RBI meeting tomorrow. According to my quantitative models the PHP and TWD will underperform.

Draghi shakes things up

European Central Bank President Draghi shook things up overnight providing a major backstop for risk assets. Draghi effectively noted that the ECB “is going to do whatever is necessary to preserve the EUR”. The aggressiveness of his comments left no doubt that the ECB chief means business.

Whether this translates into renewed bond buying by the central bank is debatable but this is what the market is now hoping for at next week’s ECB policy meeting. Anything less would provoke disappointment.

At the least Draghi has helped to put a floor under the EUR ahead of the policy meeting. After dropping to a low around 1.2117 the currency bounced sharply but its gains were exhibited mainly against the USD rather than on the crosses. Further short covering could see EUR/USD move up to around the 1.2350 resistance level but much further gains are expected to be limited.

The biggest beneficiaries of Draghi’s comments were equity volatility which dropped sharply and Spanish stocks, which rallied by over 6% yesterday. Gold also rallied in the hope of central bank action next week. In terms of Asian currencies, those most sensitive to risk gyrations including KRW, MYR, INR and IDR will be the biggest beneficiaries.

Attention today will turn to data releases including July German inflation data and Q2 US GDP. A weak US GDP may put a bit of a dampener on sentiment especially as it will highlight the sharp slowing in growth over the quarter.

Nonetheless, markets are likely to move into consolidation mode ahead of next week’s ECB and Fed meetings, with risk assets generally supported by expectations / hopes of policy actions by both or either central bank. One index which remains on a downward trajectory is the Baltic Dry Index, which dropped further overnight, highlighting the growing risks to the global economy.

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