Thursday, April 30, 2020

Will today’s ECB monetary policy decision help bulls break the 1.0900 key level for EUR/USD?

Tags
  • Dollar
  • Euro
  • European Central Bank

04302020a_ta

Analysts’ Pick: Will today’s ECB monetary policy decision help bulls break the 1.0900 key level for EUR/USD?

  • PEPP is likely to be expanded to help support a possible fiscal stimulus package from EU leaders
  • Easing of the capital key requirement can be a consideration for the ECB to support countries more affected by the virus pandemic
  • Risks skew EUR/USD to the upside later today, as risk aversion eases and more action by the ECB will likely boost investor sentiment

The European Central Bank (ECB) looks likely to increase the size of its Pandemic Emergency Purchase Programme (PEPP) during its monetary policy meeting today. We expect an increase of roughly 250bn euros, implicitly to support a possible stimulus package from EU leaders. As a result, we do see more upside for EUR/USD for the day as risk aversion continues to ease as well.

There will be several dynamics for the ECB's decision later today. Since March, the central bank has:

  1. Left its key interest rates unchanged
  2. Increased net asset purchases by a total of 870bn euros; 120bn euros for the private sector purchase programmes and 750bn euros for its new PEPP
  3. Expanding the range of eligible assets under the corporate sector purchase programme (CSPP) to non-financial commercial papers
  4. Waived eligibility requirements for securities issued by the Greek government for the PEPP
  5. Eased collateral requirements for loans to banks to accept some junk bonds as collateral

The key to today's decision will be how much the ECB is willing to expand its asset purchase programmes to help support a sharp decline in the EU's economy. An issue remains for the central bank in which it will be following its capital key for allocation of its asset purchase programmes which restricts the bank in decisions to help certain economies that have been more affected by Covid-19 infections as compared to others. Changes to interest rates has a low probability, as cutting rates deeper into negative territory is unlikely to encourage much more borrowing. Overnight Index Swaps signals that the financial market also mostly agrees, pricing in only an implied probability of 13.1% for a rate cut.

Overnight Index Swaps signal that financial markets don’t expect a rate cut at today’s meeting

04302020b_ta

We expect the ECB to expand its PEPP purchases to 1tn euro overall to prevent sudden spikes in the debt market, while emphasising the need for fiscal stimulus to prevent the sharp contraction in the EU economy being prolonged. Q1's GDP figure is set to be released today as well, and economists' are forecasting a decline of 3.8% QoQ and 3.4% YoY. With reports saying that ECB President Christine Lagarde telling EU leaders that the ECB's base case scenario forecasts the EU to contract 9% this year and up to 15% in its worst-case scenario, it seems likely that the central bank will decide to add funds to its stimulus packages.

Italy saw the most cases and deaths from the Covid-19 pandemic among the three biggest economies in the EU

04302020c_ta

Most of the risks for the EU are also skewed to the downside, since most of the EU's major trading partners are on lockdown as well, with the exception of China, who just reopened its economy in late March. Lockdowns should also be expected to only be incrementally eased, which implies only an incremental economic recovery as well, instead of the initial v-shaped recovery. This should hold true in the short-to-medium-term even with Gilead's new experimental drug showing positive effects to speed up the recovery rate of Covid-19 patients in its latest test. This is due to the time it will take to manufacture the new drug in addition to additional tests it needs to complete before being readily available to the general public. Coupled with easing risk aversion in the market thanks to the positive news from Gilead, the greenback is likely to continue to fall in the short-term.

With respect to its capital key, we think that the ECB may ease its capital key to extend more help to heavily affected countries in the bloc. While this could already in place, as the central bank said in its latest monetary policy statement that the PEPP will follow the capital key and at the same time purchases under the programme will be conducted in a "flexible manner". The reason that the ECB may do this is to help Italy avoid a debt crisis. Even with the PEPP, yields on Italy's 10-year government bonds are continuing to rise, signalling that the government may be unable to service its debt if yields continue to rise.

Italy’s 10-year government bond yields continue to rise after the announcement of the PEPP in contrast to German 10-year yields

04302020d_ta

Capital keys may be preventing ECB from lowering Italy and Spain’s yield spread to German bonds

04302020e_ta

The damage done to the country stemmed from a surge in the number of coronavirus cases in the northern area, which is home to most of the country's manufacturing sector. Easing the capital key requirement will allow the ECB to focus on harder hit countries in the bloc to maintain smooth functionality of the respective debt markets. From the graph below, Both Spain and Italy are on the same trajectory. With the capital key requirement, Germany and France will be eligible for more, which contrasts allocation based on needs. But of course, there not all of the ECB officials will agree since it would be less beneficial for their own country.

The capital key requirement signals that Germany and France will get bulk of the aid from the PEPP

04302020f_ta

Hence, the upside for the EUR/USD are more prominent today, as the ECB looks likely to ease monetary policy further and as investors increase their risk appetite. We thus expect EUR/USD to break past 1.0890's level today, to retest the 38.2% Fibonacci retracement level of 1.0900. Downsides to this strategy will include the ECB not making any changes to its monetary policy, as well as negative news as pertaining to the Covid-19 virus (i.e. data showing the ineffectiveness of Gilead’s drug or a second wave of the virus in or out of the EU).

Technical Analysis:         

EUR/USD

Euro bulls have benefitted from the recent news, which has all skewed towards a more positive note. With lockdowns easing and Gilead’s new experimental drug having positive effects on recovery rates in its latest test, euro bulls will likely test the resistance level of 1.0890. Our Fibonacci retracement indicates that the currency pair is trading close to the 38.2% level, which if broker should send the euro higher as more traders may buy into the key level to take advantage of a momentum strategy. The Stochastic oscillator also signals that the euro has more room to rise before trading in the overbought level. As a result, we see EUR/USD possibly breaking 1.0890’s level if the ECB eases again at today’s monetary policy decision.

Support: 1.0844 / 1.0817 / 1.0756

Resistance: 1.0890 / 1.0923 / 1.0986

EUR/USD Chart (H4)

04302020g_Ta