Euro to Fall as ECB Prepares Market for More Easing

The biggest story in the foreign exchange market today was ECB President Mario Draghi's surprisingly dovish comments on monetary policy. Many economists believed he would avoid making specific comments about more policy action but as we pointed out in yesterday's note, the 3-cent rise in the euro and decline in oil prices since December encourages the ECB head to be characteristically dovish. Now he went one step further by saying that the central bank "will possibly reconsider its policy stance in March." Draghi could not be any clearer in suggesting that they may increase stimulus at the next meeting (there is no meeting in February) and for this reason we believe the euro should trade lower. He said the ECB has the power, determination and willingness to act with plenty of instrument at their disposal. Even though economic activity improved in the month of December, recent market developments gives the central bank many causes for concern. The ECB is worried about the volatility in commodity markets, the geopolitical landscape and the slowdown in emerging markets. Oil prices are 40% lower than when they last released their economic projections and this decline puts inflation at very low and even negative levels according to Draghi.

We see a 90% chance of ECB easing in March. Draghi's desire to be "vigilant" on the risks of a downward price spiral and his resistance to "surrendering to global factors" tell us that the central bank doesn't want to be caught behind the curve. That 10% chance of no change will only occur if oil prices suddenly rocket higher or China sweeps in with a major stimulus program that turns risk appetite and the markets around. Of course, how much easing the central bank offers is up in the air. In December they under delivered when they failed to lower the deposit rate and increase the amount of bonds purchased so these are the 2 obvious options they could employ in March. From now until March 10th, the euro will be a sell on rallies.

The biggest mover today was the Canadian dollar, which lost more than 1.5% of its value versus the greenback. After rising for 12 straight trading days, we have now seen the strongest reversal in at least 3 months and we're calling this a near term top in USD/CAD. Between the Bank of Canada's optimism, the more than 6% intraday recovery in oil prices and the prospect of stronger Canadian data on Friday, we are looking for USD/CAD to test 1.40. Canadian retail sales and consumer prices are scheduled for release tomorrow. While economists are looking for muted reports, the sharp rise in wholesale trade and jump in the price component of IVEY PMI points to stronger numbers.

With so many big stories outside of the U.S., it is not surprising to see mixed performance in the U.S. dollar. The greenback traded higher versus the Japanese Yen, euro, and Swiss Franc but struggled against the British pound, Canadian, Australian and New Zealand dollars. At the start of the week we said the dollar would not be a focus due to the lack of market moving data. This morning's mixed U.S. economic reports had very little impact on the dollar. Jobless claims rose to a 6 month high but continuing claims extended their slide. The Philadelphia Fed index came in better than expected printing at -3.5 versus a -5.9 forecast. Markit Economics' manufacturing PMI report is scheduled for release tomorrow along with existing home sales. We don't expect either of these reports to have a significant impact on the U.S. dollar.

Sterling is in play tomorrow with U.K. retail sales scheduled for release. After falling to a fresh 5 year low of 1.4081, GBP/USD recovered strongly during the North American trading session to end the day virtually unchanged. Economists are looking for spending to fall, which would be in line with slowing wage growth but fewer jobs were lost according to the most recent report and the British Retail Consortium reported a small uptick in spending after the sharply fall in November. So tomorrow's report may not be as weak as feared.

The prospect of more easing from the ECB has made higher yielding currencies such as the Australian and New Zealand dollars more attractive. Both AUD and NZD rose more than 1% against the U.S. dollar and Euro. Data from New Zealand was better than expected with consumer confidence rising in January and business manufacturing activity accelerating. In Australia however, job ads grew at a slower pace in December, consumer inflation expectations eased in January and new home sales fell by a smaller amount. No economic reports are scheduled for release from either country on Friday so keep an eye on commodity prices.

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