Post ECB, EUR, Scandi FX and CEEMEA

EUR: Draghi achieving the unachievable

Despite reducing the pace of monthly ECB QE asset purchases, Drahgi’s dovish stance and technical adjustments to the QE programme actually weighed on EUR (as short dated German Schatz yields declined). More downside to EUR/USD due to EZ politics and higher UST yielders in coming months. The undervalued SEK is the main beneficiary in the European FX space. More uncertainty to PLN and HUF and scope for more downside to EM high yielders.

The ECB extended its QE programme by three more quarters until end-2017, yet it reduced the pace of purchases from €80bn to €60bn per month. Although EUR/USD initially rallied, it is now 1% lower. This is because: (1) Draghi did whatever it took to downplay the tapering concerns (tapering was apparently not discussed by the Governing Council); (2) ECB keeps in place the option to increase the monthly pace of QE purchases again should it be necessary (ie, if the risk to inflation increases) ; and (3) technical adjustments to the QE programme – decreasing the minimum maturity of bonds being purchased from 2-years to 1-year, scrapping the depo floor limit on these purchases.

Points (1) and (2) imposed a limit on the extent to which longer dated bunds sold off, which in turn limited the upside to the EUR as the longer dated yield differential between the US and Eurozone did not narrow materially. Point (3) has actually put an active downside to the EUR as it has led to a non-negligible decline in short-dated German Schatz yields, a wider US-EZ short dated spread and, hence, lower EUR/USD.

The above dynamics are clearly evident within our EUR/USD short term financial fair value model, which identifies the current EUR/USD levels as fair (Figure 1). In fact, the short-term EUR/USD fair value declined by more than 1% since yesterday due to the decline in short dated EZ yields.

More downside to EUR/USD in coming months

With Draghi being close to 100% successful in avoiding the taper-like EZ bond sell off and in fact generating lower short-dated EZ yields, the EUR/USD upside should be very limited in coming weeks/months. We look for the EUR/USD to move towards the 1.02 level in 1Q17 as: (1) the busy EZ political calendar weighs on the EUR via an increase in EUR risk premium; and (2) there is potential for another leg in UST yields higher in 1Q17.

Today’s ECB decision is favouring SEK, but adding some downside to G10 and EM higher yielders, while rising uncertainty about CEE FX.

SEK – Potential for less dogmatic Riksbank

SEK has been one of the key beneficiaries of today’s ECB announcement as the lower pace of ECB asset purchases suggests that Riksbank should ease its dogmatic approach. While we still expect the Riksbank to extend its own QE programme into 1H17 (by SEK25-30bn in total), there may be a less of a need for a rate cut. Importantly, SEK remains still meaningfully undervalued.

Risks to higher yielding FX and CEE currencies

The ECB reducing the pace of asset purchases should on the margin take some support away from G10 and EM high yielders as: (1) less extra liquidity will be pushed into the system; (2) potential for higher core yields. Hence, the negative knee jerk reaction in AUD and NZD in the G10 FX space.

In the EM, currencies such as TRY, ZAR or MXN are vulnerable. In our view, TRY remains particularly at risk given its high sensitivity to core yields, tricky domestic politics, concerns about the CBT credibility and the very high bar for an emergency rate hike. We continue to favour long RUB/TRY positions given RUB’s lower vulnerability to higher core yields.

In the CEE FX space, steeper bund yield curve and higher longer dated bund yields put PLN and HUF at risk. Moreover, should the lower pace of ECB bond buying increase concerns about the Italian banks recapitalisation process and rise EUR risk premium, PLN and HUF are likely to suffer. Overall, it will be a very tricky 1H17 for the forint and the zloty.