Is the ECB pushing EURUSD to parity to fight Trump trade war 2.0?

·         EU is the biggest victim of the Ukraine war and US/Trump trade war policies; EURUSD now turning into a carry trade currency rather than a growth currency

·         Also lack of structural reforms, excessive fiscal austerity, and political & policy paralysis, the EU may be now facing a stagflation, if not an all-out recession

On Thursday, apart from US economic data and Fed rate action, some focus of the market was also on the ECB’s monetary policy decision. As highly expected, the ECB cut all three key rates by -25 bps. Accordingly, the ECB rates on the deposit rate facility (DRF-reverse repo), reference rates on the main refinancing operations (MRO-interbank rate), and rates on the marginal lending facility (MLF-repo rate) will be decreased to 300%, 3.16%, and 3.40% respectively, with effect from 18th December’24 (coinciding with Fed’s expected rate cut 25 bps).

Full Text of ECB statement: Monetary policy decisions: 12the December’24

“The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate – the rate through which the Governing Council steers the monetary policy stance – is based on its updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission.

The disinflation process is well on track. Staff sees headline inflation averaging 2.4% in 2024, 2.1% in 2025, 1.9% in 2026, and 2.1% in 2027 when the expanded EU Emissions Trading System becomes operational. For inflation excluding energy and food, staff projects an average of 2.9% in 2024, 2.3% in 2025 and 1.9% in both 2026 and 2027.

Most measures of underlying inflation suggest that inflation will settle at around the Governing Council’s 2% medium-term target on a sustained basis. Domestic inflation has edged down but remains high, mostly because wages and prices in certain sectors are still adjusting to the past inflation surge with a substantial delay.

Financing conditions are easing, as the Governing Council’s recent interest rate cuts gradually make new borrowing less expensive for firms and households. But they continue to be tight because monetary policy remains restrictive and past interest rate hikes are still transmitting to the outstanding stock of credit.

Staff now expects a slower economic recovery than in the September projections. Although growth picked up in the third quarter of this year, survey indicators suggest it has slowed in the current quarter. Staff sees the economy growing by 0.7% in 2024, 1.1% in 2025, 1.4% in 2026 and 1.3% in 2027. The projected recovery rests mainly on rising real incomes – which should allow households to consume more – and firms increasing investment. Over time, the gradually fading effects of restrictive monetary policy should support a pick-up in domestic demand.

The Governing Council is determined to ensure that inflation stabilizes sustainably at its 2% medium-term target. It will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. 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. The Governing Council is not pre-committing to a particular rate path.

Key ECB interest rates

The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. Accordingly, the interest rates on the deposit facility, the main refinancing operations, and the marginal lending facility will be decreased to 3.00%, 3.15% and 3.40% respectively, with effect from 18 December 2024.

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

The APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities.

The Eurosystem no longer reinvests all of the principal payments from maturing securities purchased under the PEPP, reducing the PEPP portfolio by €7.5 billion per month on average. The Governing Council will discontinue reinvestments under the PEPP at the end of 2024.

Refinancing operations

Banks will repay the remaining amounts borrowed under the targeted longer-term refinancing operations this month, which concludes this part of the balance sheet normalization process.

***

The Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation stabilizes sustainably at 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: 12th December’24

“The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate – the rate through which we steer the monetary policy stance – is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission.

The disinflation process is well on track. Staff sees headline inflation averaging 2.4 percent in 2024, 2.1 percent in 2025, 1.9 percent in 2026 and 2.1 percent in 2027 when the expanded EU Emissions Trading System becomes operational. For inflation excluding energy and food, staff projects an average of 2.9 percent in 2024, 2.3 percent in 2025 and 1.9 percent in both 2026 and 2027.

Most measures of underlying inflation suggest that inflation will settle at around our two percent medium-term target on a sustained basis. Domestic inflation has edged down but remains high, mostly because wages and prices in certain sectors are still adjusting to the past inflation surge with a substantial delay.

Financing conditions are easing, as our recent interest rate cuts gradually make new borrowing less expensive for firms and households. But they continue to be tight because our monetary policy remains restrictive and past interest rate hikes are still transmitting to the outstanding stock of credit.

Staff now expects a slower economic recovery than in the September projections. Although growth picked up in the third quarter of this year, survey indicators suggest it has slowed in the current quarter. Staff sees the economy growing by 0.7 percent in 2024, 1.1 percent in 2025, 1.4 percent in 2026 and 1.3 percent in 2027. The projected recovery rests mainly on rising real incomes – which should allow households to consume more – and firms increasing investment. Over time, the gradually fading effects of restrictive monetary policy should support a pick-up in domestic demand.

We are determined to ensure that inflation stabilizes sustainably at our two percent medium-term target. We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. 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. We are not pre-committing to a particular rate path.

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 grew by 0.4 percent in the third quarter, exceeding expectations. Growth was driven mainly by an increase in consumption, partly reflecting one-off factors that boosted tourism over the summer, and by firms building up inventories. But the latest information suggests it is losing momentum. Surveys indicate that manufacturing is still contracting and growth in services is slowing. Firms are holding back their investment spending in the face of weak demand and a highly uncertain outlook. Exports are also weak, with some European industries finding it challenging to remain competitive.

The labor market remains resilient. Employment grew by 0.2 percent in the third quarter, again by more than expected. The unemployment rate remained at its historical low of 6.3 percent in October. Meanwhile, demand for labor continues to weaken. The job vacancy rate declined to 2.5% in the third quarter, 0.8 percentage points below its peak, and surveys also point to fewer jobs being created in the current quarter.

The economy should strengthen over time, although more slowly than previously expected. The rise in real wages should strengthen household spending. More affordable credit should boost consumption and investment. Provided trade tensions do not escalate, exports should support the recovery as global demand rises.

Fiscal and structural policies should make the economy more productive, competitive, and resilient. It is crucial to swiftly follow up, with concrete and ambitious structural policies, on Mario Draghi’s proposals for enhancing European competitiveness and Enrico Letta’s proposals for empowering the Single Market. We welcome the European Commission’s assessment of governments’ medium-term plans for fiscal and structural policies, as part of the EU’s revised economic governance framework. Governments should now focus on implementing their commitments under this framework fully and without delay. This will help bring down budget deficits and debt ratios on a sustained basis while prioritizing growth-enhancing reforms and investment.

Inflation

Annual inflation increased to 2.3 percent in November according to Eurostat’s flash estimate, from 2.0 percent in October. The increase was expected and primarily reflected an energy-related upward base effect. Food price inflation edged down to 2.8 percent and services inflation to 3.9 percent. Goods inflation went up to 0.7 percent.

Domestic inflation, which closely tracks services inflation, again eased somewhat in October. But at 4.2%, it remains high. This reflects strong wage pressures and the fact that some services prices are still adjusting with a delay to the past inflation surge. That said, underlying inflation is overall developing in line with a sustained return of inflation to target.

The increase in compensation per employee moderated to 4.4 percent in the third quarter from 4.7 percent in the second. Amid stable productivity, this contributed to slower growth in unit labor costs. Staff expects labor costs to increase more slowly over the projection horizon as a result of lower wage growth and higher productivity growth. Moreover, profits should continue to partially offset the effects of higher labor costs on prices, especially in the near term.

We expect inflation to fluctuate around its current level in the near term, as previous sharp falls in energy prices continue to drop out of the annual rates. It should then settle sustainably at around the two percent medium-term target. Easing labor cost pressures and the continuing impact of our past monetary policy tightening on consumer prices should help this process. Most measures of longer-term inflation expectations stand at around 2 percent, and market-based indicators of medium to longer-term inflation compensation have decreased measurably since the Governing Council’s October meeting.

Risk assessment

The risks to economic growth remain tilted to the downside. The risk of greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy. Lower confidence could prevent consumption and investment from recovering as fast as expected. This could be amplified by geopolitical risks, such as Russia’s unjustified war against Ukraine and the tragic conflict in the Middle East, which could disrupt energy supplies and global trade. Growth could also be lower if the lagged effects of monetary policy tightening last longer than expected. It could be higher if easier financing conditions and falling inflation allow domestic consumption and investment to rebound faster.

Inflation could turn out higher if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices by more than expected. By contrast, inflation may surprise on the downside if low confidence and concerns about geopolitical events prevent consumption and investment from recovering as fast as expected, if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly. Greater friction in global trade would make the euro area inflation outlook more uncertain.

Financial and monetary conditions

Market interest rates in the euro area have declined further since our October meeting, reflecting the perceived worsening of the economic outlook. Although financing conditions remain restrictive, our interest rate cuts are gradually making it less expensive for firms and households to borrow.

The average interest rate on new loans to firms was 4.7 percent in October, more than half a percentage point below its peak a year earlier. The cost of issuing market-based debt has fallen by more than a percentage point since its peak. The average rate on new mortgages, at 3.6 percent in October, is about half a percentage point lower than at its highest point in 2023, even though the average rate on the outstanding stock of mortgages is still set to rise.

Bank lending to firms has gradually picked up from low levels and increased by 1.2 percent in October compared with a year earlier. Debt securities issued by firms were up 3.1% in annual terms, which was similar to the increase in the previous few months. Mortgage lending continued to rise gradually in October, with an annual growth rate of 0.8 percent.

In line with our monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks remain resilient and there are few signs of financial market stress. Financial stability risks nonetheless remain elevated. The macro-prudential policy remains the first line of defense against the build-up of financial vulnerabilities, enhancing resilience and preserving macro-prudential space.

Conclusion

The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate – the rate through which we steer the monetary policy stance – is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission. We are determined to ensure that inflation stabilizes sustainably at our two percent medium-term target.

We will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. 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. We are not pre-committing to a particular rate path. In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation stabilizes sustainably at our medium-term target and to preserve the smooth functioning of monetary policy transmission.”

Highlights of ECB policy and President Lagarde’s comments during Q&A (Presser): 12th December’24

·         ECB cuts key rates by 25 bps in December monetary policy decision, as expected

·         ECB Deposit Rate Actual 3% (Forecast 3%, Previous 3.25%)

·         ECB Interest (interbank) Rate Actual 3.15% (Forecast 3.15%, Previous 3.40%)

·         ECB Cuts rates as expected, but reference to "restrictive policy" is dropped

·         ECB forecast inflation easing to 2% in 4Q/2025

·         ECB forecasts assume 2024 oil price of $81.8/barrel, 2025 $71.80, 2026 $70.10, and 2027 $69.20

·         ECB forecasts assume exchange rate of $1.06 in 2025, 2026, 2027

·         ECB forecasts assume an exchange rate of $1.08 in 2024

·         ECB cuts 2024 HICP forecast to 2.4% from 2.5%, growth outlook remains sluggish

·         The ECB’s interest rate decisions will be based on its assessment of the inflation outlook in light of incoming economic and financial data, dynamics of underlying inflation, and the strength of monetary policy transmission

·         Most measures of underlying inflation suggest that inflation will settle at around the governing council's 2% medium-term target on a sustained basis

·         Over time, the gradually fading effects of restrictive monetary policy should support a pick-up in domestic demand

·         The ECB is not pre-committing to a particular rate path

·         APP and PEPP portfolio is declining at a measured and predictable pace, as the system no longer reinvests principal payments from maturing securities

·         Eurosystem no longer reinvests all principal payments from maturing securities purchased under PEPP, reducing PEPP portfolio by €7.5 billion per month on average

·         They continue to be tight because monetary policy remains restrictive and past interest rate hikes are still transmitting to outstanding stock of credit

·         Staff see headline inflation averaging 2.4% in 2024, 2.1% in 2025, 1.9% in 2026, and 2.1% in 2027 when the expanded EU emissions trading system becomes operational

·         Staff now expect a slower economic recovery than in September projections

·         For inflation excluding energy and food, staff project an average of 2.9% in 2024, 2.3% in 2025, and 1.9% in both 2026 and 2027

·         ECB drops reference to 'keeping rates restrictive’ from the statement

·         Domestic inflation has edged down but remains high, mostly because wages and prices in certain sectors are still adjusting to past inflation surges with a substantial delay

·         Financing conditions are easing, as ECB’s recent interest rate cuts gradually make new borrowing less expensive for firms and households

ECB's President Lagarde said:

·         The neutral rate is probably a little higher than before

·         Will debate the neutral rate more as we get closer to it

·         ECB attentive to the impact of exchange rate

·         US tariffs not incorporated into ECB projections

·         PEPP flexibility has not been used since July 2023

·         I have no reason to doubt staff projections

·         A lot of ground has been covered

·         The direction of travel is very clear

·         Protectionism is short-term inflationary

·         We have not discussed the neutral rate level in the meeting

·         The neutral rate can't be determined with precision

·         I don't think about market pricing of rate hikes

·         Risk to inflation is now two-sided

·         Productivity is more promising

·         We are observing a decline in corporate profit margins

·         Reaching the goal has moved a little forward in 2025

·         Inflation is on track to reach 2% in the medium term

·         There were some discussions about 50 bps  rate cuts for this meeting

·         But the proposal of 25 bps cut was agreed by all

·         There is no victory yet against inflation

·         Financial stability risks remain elevated

·         Macro-prudential policy remains the first line of defense against the build-up of financial vulnerabilities.

·         Downside risks to inflation include low confidence, geopolitical stress, and low investment.

·         Growth is losing momentum

·         Wages, profits, and geopolitics are among the upside risks to inflation

·         Trade friction could weigh on growth

·         Risks to growth tilted to the downside

·         Most measures of inflation expectations at around 2%

·         I expect inflation to fluctuate near the current level in the near term

·         Profits to partially offset higher labor cost

·         Labor cost increases to slow

·         Underlying inflation in line with sustained return to target

·         Domestic inflation reflects wage pressure and services

·         Exports should support recovery if trade tensions don't escalate

·         Recovery is slower than expected

·         Demand for labor continues to weaken

·         The labor market is resilient

·         Firms are holding back investments

·         Exports are weak

·         Growth is losing momentum

·         The current market pricing of 50 bps cut in Jan’25 may not be appropriate

Customary ECB Sources (after ECB meeting): Forward Guidance

·         A handful of policymakers were initially in favor of a 50 bps cut

Conclusions:

In Nov’24, the annual Euro Zone HICP Core inflation (w/o energy, food, alcohol, and tobacco) was unchanged at +2.7% since Sep’24 after a substantial decline from recent top +5.7% in Mar’23 amid lower oil/energy prices (indirect transmission to core inflation), but still substantially higher than the Dec’19 (pre-COVID) levels of +1.3%. The EZ Core HICP inflation may be equivalent to US core PCE inflation based on core consumer expenditure, which is equivalent to core CPI inflation of around 2.0% (~1.8%). Now in Nov’24, the EZ core HICP inflation is stalled around +2.7% against a target of +1.3% and thus still substantially higher.

The EZ service inflation has also stuck around +4.0% for the last few months on average, still quite elevated against pre-COVID levels of +2.0%. Also, EZ rent inflation surged to +3.0% recently after hovering around +2.7% since early 2024 and quite elevated compared to +1.3% on average in pre-COVID times. The rise in service/housing/rent inflation may be due to robust travel & tourism amid a warm winter and pleasant summer in Europe this year. This coupled with a post-COVID travel boost and also increasing immigration/workers/labor force coupled with a higher population, equivalent to almost the entire US population of around 350M. This is creating higher demand for renting and housing, while supply remains constrained amid fiscal austerity, which is boosting domestic inflation. Also, a devalued EUR may cause higher imported inflation in the coming days.

The EZ core HICP disinflation may have stalled AROUND +2.7% in H2CY24 after a meaningful disinflation from +3.1% in Q1CY24. The rapid fall in annual core CPI is a favorable base effect, which may reverse in Q4CY24 and early 2025. At present and trend sequential rate, the EZ core HICP may fall to around +2.0% symmetrical levels by Dec’25, while the actual target (pre-COVID) of +2.0% symmetrical levels by Dec’26. And like in the US, the EZ inflation/price is still around +20% higher than pre-COVID CY19 levels.

The EZ core HICP inflation (w/o food, fuel/energy, alcohol, and tobacco) is different from normal core CPI inflation (w/o food & fuel/energy) even after harmonization and maybe around 1.00-0.70% lower than core CPI. The EZ HICP inflation in the Euro Area remained below +2.0% for much of the period between 2010 and 2020, often hovering around +1.0%. However, after the 2020 COVID disruption and recession effect, the EZ HICP in 2021-2022, inflation surged due to COVID-related supply chain disruptions, fiscal stimulus, and rising energy prices, though the core HICP inflation began rising more notably in mid-2022 after the Russia-Ukraine war and subsequent economic sanctions on Russia. In 2022-2023, EZ core HICP inflation accelerated, peaking around 5.7% amid persistent price pressures in services and non-energy industrial goods due to wage growth and supply bottlenecks.

The EZ real GDP growth is around +0.4% in 2023 (y/y) against an average of 1.7% in 2018-19 (pre-COVID). The trend rate of EZ real GDP growth should be around +2.0%. In H1CY24, the EZ real GDP growth was around +0.5% (y/y), while in Q3CY24, the EZ real GDP growth was around +0.9%, highest since Q1CY23 amid robust travel & tourism boost (pleasant summer). However, the manufacturing sector remains subdued due to various structural reasons including the Ukraine war. Overall, the 2024 EZ real GDP growth may come around +0.7% (y/y). The 2024 average EZ unemployment rate may be around 6.5% against pre-COVID levels of 7.5%

As per Taylor’s rule, for the ECB/EU:

Recommended policy repo rate for ECB/EU Considering inflation, unemployment, and GDP growth equations, the ECB should maintain an average repo rate of at least around +3.40% in 2024 and +1.70% in 2025. Growing real policy divergence between the Fed and ECB along with a stagflation-like scenario in the EU and political crisis & policy paralysis (France, Germany) is keeping EURUSD under stress, causing more imported inflation as the EU depends on both fuel and food imports. Thus despite the ECB narrative of translantic divergence, in the longer term, the ECB may have to follow the Fed in real policy action, whatever may be the narrative.

Looking ahead, the ECB may cut regular -25 bps each QTR end in 2025-26 in line with the Fed for a repo rate (MLF) around +1.40% by Dec’26 against core HICP inflation average +1.90%. By 2027, the EU core HICP average should be around +1.30%, which would be equivalent to a core CPI rate of around +2.00%. Thus the real rate concerning core CPI inflation would be around +0.50%.

Bottom line:

ECB should be given a Fed/US-like dual mandate of maximum employment and price stability, while EU/EZ member states should employ sufficient fiscal/infra stimulus with proper policy reform to encourage the manufacturing sector to be able to compete with China, Korea, Japan, and US for mass employment. EU/EZ has been suffering for a long time from excessive fiscal austerity and also social welfare grants (dole money), which is dragging the overall productivity of the economy. Also, Germany and various other EU states are victims of the Ukraine war. The US is provoking the EU to abandon cheap Russian NG/fuel and instead, the US is now supplying at much higher prices. Higher energy prices and the Trump/US trade war tantrum are some of the main reasons behind the German recession. All these are resulting in EUR becoming a carry trade currency rather than a growth currency.

Weekly-Technical trading levels: EURUSD

Looking ahead, Whatever may be the fundamental narrative, technically EURUSD (1.05000) has to sustain above 1.06000 for a recovery to 1.06500-1.08000 and further rally to 1.08800/1.09200-1.09500/1.10000 in the coming days; otherwise sustaining below 1.05800, EURUSD may further fall to 1.05000/1.04400-1.03000.1.100000 in the coming days.