London session: ECB currency de-valuation by stealth

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By Kathleen Brooks | February 15, 2013 12:52 AM EST

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The G20 is in full swing and to kick things off the host nation Russia called for a stronger stance regarding currency manipulation and said it wanted more "specific" language opposing exchange rate interference by governments and central banks. Today has been an interesting day for the FX market - the yen (enfant terrible of the FX world) has continued to rise sharply, while the euro (self-appointed victim of the currency wars) has fallen sharply.

Germany - the future's bright


The decline in the euro was fuelled by weaker than expected Q4 GDP. While a decline in growth was expected, the 0.6% drop was worse than the 0.4% the market predicted. The annual pace of decline was 0.9%, versus 0.7% expected. There were sharper contractions in France, Germany and Italy, the three largest economies in the currency bloc. Interestingly, the decline in German GDP in Q4 was twice that of France, on a seasonally adjusted basis. However, looking forward Germany's prospects are better than France's. The stabilisation in the global economy and in the sovereign crisis could boost the powerful German export sector, while the decline in French business surveys, including the PMI surveys that fell sharply in January, suggests that the decline in domestic corporate and household demand could be entering an intense period of decline in Q1 2013.

Could the ECB cut rates - it's a possibility, says ECB...


The weak economic data clouded some better news that Spain's banks had borrowed less from the ECB in January than they did in December. This was expected after the improvement in inter-bank lending conditions in recent months. ECB member Constancio said that deposits were rising in Eurozone banks and that peripheral nations are also seeing some encouraging signs that inflows are coming back. All good news for the currency bloc, however the market instead focused on COnstancio's comments regarding negative interest rates. He said that the Bank was "technically ready" to employ negative interest rates as a policy tool if necessary, although a decision has not been made. He did say that the impact of negative rates were not clear, however, the market interpreted it as a sign that a cut could be on the cards as soon as the March meeting. Negative interest rates relate to deposit rates - the rate paid to banks that hold cash at the ECB. Thus, if rates are negative, it costs banks to keep their cash at the safety of the ECB, which should promote lending. This is another way to improve the "transmission mechanism" of the ECB's monetary policy and get credit flowing into the real economy.

We do not believe that the ECB will cut the base rate, which is 0.75%, due to opposition from some larger members like Germany, who are concerned about inflation. However, the deposit rate is already at 0%. This adds a fresh dimension to the March ECB meeting. At this meeting the ECB staff forecasts for growth and inflation are announced. If the inflation forecast is substantially revised down then negative deposit rates could be a justified policy action. It is also a way to try and push money into the Eurozone economy without the ECB having to embark on QE.

EURUSD puts in a temporary top


The Constancio comments caused a flurry of euro selling in the London morning session, and EURUSD is 120 pips lower than it was earlier. Interestingly, EURUSD dropped after hitting resistance at 1.3450 - the 10-year average of the EURUSD rate. We think this is a temporary top for now. Support lies at 1.3280. Overall, we see EURUSD trading with a bearish bias, but losses being capped ahead of 1.30. Next week's flash PMI surveys reports will be important. If we don't see continued improvement then we could see steeper declines for EURUSD.

While the Eurozone economy is unlikely to recover if the euro continues to appreciate, the problem for the ECB and the Eurozone authorities is that other countries like Japan and the US are embarking on aggressive levels of QE and it is not. This should limit EUR losses in our view.

USDJPY - set-back only temporary due to G20, in our view


The yen and the kiwi are leading the pack in the G10 FX sphere today. The Kiwi was boosted by better than expected consumer confidence, while the yen continues its humble turn-around as we lead up to the start of the G20. The BOJ remained on hold as we expected, however, GDP was worse than expected, shrinking 0.4% in the final quarter of 2012, and the third straight decline. Recession and deflation are a powerful argument supporting what the BOJ and the government is doing. Thus the rebound in the yen could be more for diplomatic reasons. While the G20 may moan about policies that target the exchange rate, we doubt it will enforce anything to try and limit yen weakness from here, which should allow USDJPY to get above 95 towards 100 in the medium-term, although it could be a grind higher from here rather than a rollercoaster ride.

Watch out for initial jobless claims today, a couple of Fed speakers and also more comments from the G20. This could keep the yen bid for now. As long as USDJPY doesn't dip below 92.20 we are still constructive on more medium-term gains for this pair, although the road to 95.00 is littered with a giant G20 obstacle in the short-term.

One to Watch: EURUSD - downside limited



Best Regards,

Kathleen Brooks| Research Director UK EMEA |

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e:| w:

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