EUR/JPY Forecast: Overbought, stuck at monthly 100-MA hurdle, hawkish surprise likely from ECB

Bond markets are betting a further stimulus from the European Central Bank is a done deal. Eurozone bonds, including those of Italy, rallied this week, despite Italy’s “no vote” in a referendum on constitutional reforms.

This clearly suggests the markets expect the ECB will extend the maturity of its QE program by six months to September 2017. The central bank buys EUR 80 billion worth of assets each month.

Maturity extension priced-in

A mere extension of the maturity won’t do any damage to the common currency, given the move has been priced-in. However, no extension of the maturity program would be read as a sign that the central bank could be heading towards “Taper” in 2017. This would lead to a broad based spike in the EUR.

ECB - QE overdone, inflation target nowhere in sight

The central bank holds almost 25 percent of the region’s covered bonds after starting purchases about two years ago. The shopping list includes sovereign and corporate debt.  Despite the massive purchases, the bank is nowhere close to its 2% inflation target. Moreover, there is little evidence/little reason to believe the bank would achieve its inflation target any time soon.

Furthermore, the availability of bonds is something the bank should be worried about. If it intends to boost/continue its QE program, the bank would have to either-

• Ditch the deposit rate conditionality (EUR sell-off) 
• Cut the deposit rate (Knee jerk sell-off in EUR, followed by a recovery)

As of now, the ECB buys bonds with yields above its deposit rate of -0.40%. As of November 2016, 23% of euro zone government bonds yielded less than the ECB's deposit rate of minus 0.4%, which marks the lower limit for QE purchases.

EUR would take a hit if the ECB ends the deposit rate conditionality.

On the other hand, a rate cut could yield a knee-jerk sell-off, followed by a quick fire recovery (as seen in the past after rate cut action).

ECB could engineer a steeper yield curve

The ailing banking sector across the Eurozone needs a steeper yield curve. The ‘near exhaustion’ status of the ECB means a steeper yield curve is inevitable. One way the bank could do it is signal a possible Taper in 2017.

As mentioned earlier, a status quo policy would force markets to consider the possibility of a ‘QE’ Taper in 2017. This appears to be the most likely outcome of the ECB rate decision today. EUR stands to rally in this case… more so because the risk assets could take a hit, thus leading to carry unwind and the strength in EUR, although the common currency may remain flat against the JPY.

EUR/JPY - Battle of the funding currencies

Monthly chart

• The pair failed to take out 123.07 (38.2% of Jul 2008 high - Jul 2012 low) - 123.36 (monthly 100-MA).
• The cross is overbought as per the daily RSI. The daily MACD suggests the bullish momentum is running out of steam.
• Thus, sideways to negative action in the range of 120.50-123.00 is likely in the short-run
• On the higher side, a break above 123.36 would open doors for 125.00 levels.
• On the lower side, only a dip below 120.00 levels would suggest the rally from the June low of 109.42 has ended.