EUR/USD strategy is to buy on dips

• Yesterday’s ECB meeting was fairly uneventful. The Governing Council left its monetary policy unchanged, in line with expectations, and confirmed all the most important parts of its communication. The key theme of the Governing Council discussion was the increased confidence that a faster narrowing of the output gap will eventually push underlying inflation higher. But we note that, despite clearly stronger GDP forecasts, the ECB’s own projections for core inflation have actually been revised further down throughout next year, de facto delaying the time of a clearer acceleration to 2019 and 2020 (when, however, the uncertainty surrounding the forecasts increases strongly). This explains why Draghi has to remain dovish and monetary policy very accommodative despite the bullish growth news. However, this will also raise communication challenges for the ECB going forward.
• Yesterday there were no relevant rhetoric changes compared to the October meeting, when the ECB announced its plan to halve the pace of net monthly purchases to EUR 30bn starting in January. The ECB confirmed all its guidances, with interest rates expected to remain at the current level "well past" the end of net asset purchases, the possibility to extend/increase the QE program if needed, and the reinvestment of the maturing securities for an extended period of time after the end of net purchases. The only perceptible change in tone refers to the ECB’s increased optimism about the growth outlook – and rightly so – and confidence that this will eventually feed through to underlying price pressure. But looking beyond the surface and focusing on numerical details, the story that emerges puts the ECB in a tricky position. The new macroeconomic projections explain why.
• As expected, the ECB revised its growth forecasts clearly higher, now envisaging 2.4% GDP expansion this year (previous: 2.2%), 2.3% in 2018 (1.8%), 1.9% in 2019 (1.7%) and 1.7% in 2020. The numbers throughout 2019 are in line with our own forecasts. However, this more bullish growth projections still fail to generate meaningful spillover to the inflation forecasts, given that the only upward revision for CPI was front-loaded (in 2018), modest (to 1.4% from 1.2%) and totally energy-driven, while at the policy-relevant horizon in 2020 headline inflation is expected to average 1.7%, not quite in line with the ECB’s definition of price stability. The key issue here is that these numbers come with a further downward revision of the ECB’s forecasts for core inflation in the first part of the forecast horizon, with 2018 now seen at 1.1% from 1.3%. This leaves almost the entire reacceleration in core inflation in 2019 (1.5%, in line with the September estimate) and in 2020 (1.8%).
• Given the increased uncertainty surrounding longer-term forecasts, it is the one-year-ahead projection that usually bears the most important practical implications for monetary policy. This puts the ECB in a tricky position: the Governing Council has been facing steady upside growth surprises over the last year or so, which most likely imply a faster narrowing of the output gap than originally expected. Relative to the September forecasts, this time even compensation forecasts for 2017 and 2018 have been raised slightly, not to mention the technical assumption of oil prices being 10-20% higher across the forecast horizon. Yet, core inflation for next year is expected to be weaker than in the September forecasts. The ECB has only one mandate – price stability – and this vindicates prudence, persistence and patience in monetary stimulus. However, lack of responsiveness in core inflation at a time of strong growth complicates ECB communication, probably explaining why the range of views within the Governing Council about the appropriate end-date of QE has been broadening of late.
• Draghi’s task will not be any easier after telling us yesterday that the ECB expects the output gap to close sometime in 2018. It is likely that the prospect of the ECB sticking to negative rates while there is no more slack in the economy will make a number of Governing Council’s members increasingly uncomfortable down the road.
• After yesterday’s adjustments, the ECB’s core inflation forecast for 2018 even looks slightly conservative, but downward revisions for the 2019-2020 numbers are likely in the next few quarters even if growth continues to power ahead. This will probably require a good deal of balancing act by the ECB. Overall, we continue to like our forecast that the ECB will terminate QE in December 2018 after a very quick tapering in the fourth quarter of 2018. We expect the first increase in the deposit rate in mid-2019 when the upward trend in core inflation should become more entrenched, and an exit from negative rates at the end of 2019.
• In Germany the SPD executive committee will decide on whether the Social Democrats start exploratory talks with the CDU/CSU on a government participation.After the meeting of party leaders and party whips of the CDU/CSU and the SPD on Wednesday evening, senior politicians of the CDU/CSU basically ruled out a minority government tolerated by the Social Democrats. A so-called “cooperation coalition” in which SPD ministers participate in the government but cooperate only on selected topics was also rejected by the conservatives. In contrast, at its party convention last week, the top brass of the Social Democrats promised an unbiased and open dialogue with the CDU/CSU in which various options will be discussed. Despite the latest tensions, we expect the SPD to officially announce today the start of exploratory talks with the CDU/CSU on a renewed grand coalition.
• U.S. Senate Republicans face tightening margins on the US tax reform vote as Florida senator Marco Rubio said he would not vote for the package unless changes were made to child tax credits. A compromise plan is set to be released today and final votes planned for early next week.
• The U.S. dollar looks set to end the week slightly lower following its strongest gain last week since mid-December 2016. The recent miss in U.S. CPI alongside the two dissents in the latest FOMC meeting (Charles Evans and Neel Kashkari preferred to maintain rates unchanged) seem to have weighed on dollar sentiment and led to some profit taking. On a structural basis, we remain USD bears and EUR bulls. And the ECB press conference yesterday – though uneventful and lacking “fireworks” – did not send any signals of discomfort with the stronger euro. In that sense, our view is that it does not represent a hurdle to further gradual currency gains.

Technical analysis and trading signals:

• 55-dma lends support at 1.1756 and the slow stochs continue to rise. However, the close back inside the daily cloud, 1.1669/1.1823 and EUR/USD bulls are still waiting for a break above the cloud’s top.
• We think that current levels are still good opportunity to open long EUR/USD positions.

GBP/USD: BoE in wait-and-see mode

Macroeconomic overview:

• The Monetary Policy Committee of the Bank of England voted unanimously to maintain the stance of monetary policy at its meeting that ended on Wednesday, in line with prior expectations. At its previous meeting in November, the MPC raised the bank rate by 25bp to 0.50% and signaled that market expectations for a further two 25bp hikes over the next three years were broadly consistent with returning inflation to the 2% target in three years’ time. At its December meeting the Committee reiterated this guidance, however the MPC minutes signaled increased optimism on the economic outlook following recent progress in Brexit talks and the Chancellor’s fiscal easing. The better news was partly offset by signs of softer activity in the near term than the MPC previously expected. Overall, this was a time for a pause, with the MPC waiting to see the effects of the November rate rise, as well as progress in Brexit talks, which they will assess in more detail at the February Inflation Report.
• The MPC minutes focused on the main developments of the last month. The Committee said there were two significant events: the Chancellor’s Autumn Budget – in which fiscal policy was eased by around 0.3% of GDP over the next three years – and the progress made in the first phase of Brexit talks, which the Committee judges will “reduce the likelihood of a disorderly exit, and was likely to support household and corporate confidence”. The implications of the slight loosening of fiscal policy are straightforward: it would facilitate a slightly tighter monetary policy, all else equal. In contrast, the MPC has previously warned that the implication of any resolution of uncertainty in Brexit negotiations is not immediate for the direction of monetary policy – it will depend on its impact on demand, supply and the exchange rate. The MPC said it will undertake a more detailed assessment of this in February, which is also when it will conduct its annual reassessment of supply-side conditions.
• This increased optimism on the outlook was somewhat offset by recent macroeconomic data that, while limited, had suggested GDP growth in the fourth quarter of 2017 may be “slightly softer” than the 0.4% qoq growth in the third quarter of 2017. Data on UK economic activity has been mixed over the last month or so, but on balance it suggests only modest growth, and a turning point in the labour market. Indeed, the services PMI fell back to 53.8 in November, below its long-run average of 55.1. And, in the three months to October, the quarterly change in employment was -56k – the biggest drop in more than two years. With employment now going into reverse, economic growth will hinge on productivity growth, which has been particularly weak since the financial crisis and, more recently, adversely affected by Brexit-related uncertainty.

Technical analysis and trading signals:

• The GBP/USD is again above 61.8% fibo of September-October fall, but the upward move is not being continued today. We think that a full retracement of the above-mentioned move to 1.3655 is likely in the coming days, but there is an important resistance level ahead – December 1 high at 1.3549.
• Despite bullish view on the GBP/USD, we stay sideways. We do not want to increase risk on our portfolio with another USD-bearish position.

USD/CAD: Poloz boosts rate hike bets

Macroeconomic overview:

• The Bank of Canada is increasingly confident the economy will need less stimulus over time, Governor Stephen Poloz said on Thursday. His speech boosted the Canadian dollar and raised expectations of another rate hike early in 2018.

• Poloz said the economy was in a sweet spot after making "tremendous" progress over the last year, with early signs that a long-awaited rotation to higher exports and business investment is happening as the housing boom cools.
• The economy "is close to reaching its full potential. We are very encouraged by this, and we are growing increasingly confident that the economy will need less monetary stimulus over time," Poloz said.
• While a mechanical approach to setting policy would suggest rates should already be higher, the bank still sees signs of ongoing but diminishing slack in the labor market, Poloz said. Canada's economy is near capacity and growth is forecast to continue above potential, posing an upside risk to the inflation forecast, he added. At the same time, labor market slack poses a downside risk, Poloz said, reiterating the bank's oft-repeated concern that the job market is not as strong as employment growth and a steadily declining unemployment rate would suggest.
• While the central bank held rates steady last week, Poloz acknowledged that current monetary policy "clearly remains quite stimulative" despite rate hikes in July and September, fueling market bets the next hike will come in the first quarter of 2018. The next policy meeting is January 17.
• Chances of a rate hike by January edged up to 32%, while the implied probability of a tightening by March climbed to 68% from 61% before the speech.
• Resales of Canadian homes rose 3.9% in November from October, the fourth straight monthly rise, but the momentum may not last as stricter mortgage rules take effect in January, the Canadian Real Estate Association said.
• Statistics Canada said Canadian household debt as a share of income reached a record high of 171.1% in the third quarter. The report is likely to reinforce concerns that consumers could run into trouble as interest rates rise.

Technical analysis and trading signals:

• Yesterday’s USD/CAD low was at 1.2713, close to 23.6% fibo of September-October rise. The USD/CAD returned to 14-day exponential moving average at the end of Thursday, but the fall is being continued today. The pair is going to take another attempt to break below the above-mentioned fibo level today. The next support level would be 1.2624 low on December 5.
• We stay short for 1.2500.