FX up on reduced political risks, ECB easing "not if, but how much"

USDCNY eased towards 7.14, and all EM Asian currencies recorded gains for the day.In the face of weak data, the weight of further monetary easing is squarely on the European Central Bank.
Chang Wei Liang, Radhika Rao05 Sep 2019
    Photo credit: AFP Photo

    FX: Reduced political risks welcome

    Hong Kong’s leader, Carrie Lam, announced yesterday that the extradition bill, which had sparked months of civil unrest, will be formally withdrawn. Hopes are lit on a possible de-escalation in the coming weeks. The Hang Seng Index rallied as soon as reports flagged the impending announcement, with the property sub-index up by 7.4% from the previous close. The positive turn in sentiment towards Hong Kong aided a broad firming in regional equities and currencies. USDCNY eased towards 7.14, and all EM Asian currencies recorded gains for the day. China’s state council is now calling for a timely reduction in both broad and targeted reserve ratio. This may provide a fillip for Asian currencies today, if inflows to the region are revived on prospects of Chinese stimulus.

    Another pleasant political development is that Italy’s Five Star Movement supporters have agreed to a coalition with the moderate PD. Previous concerns over a deadlocked legislature are thus soothed. The UK offers further relief after Parliament voted to block a no-deal Brexit again, followed by a rejection of PM Johnson’s call for early elections on Oct 15. Three defeats for the PM sets the stage for an extension of the Brexit date, providing valuable time for renegotiations. GBPUSD rebounded towards mid-1.22, but we expect GBP to remain weighed as no-deal risks are reduced but not fully eliminated.

    Eurozone: ECB easing “not if, but how much”

    Second estimate of Eurozone GDP growth due tomorrow will confirm that the bloc expanded at half the pace of 1Q in 2Q, at 0.2% QoQ. Germany, is under recession watch as business surveys soften, weighed by car-industry woes and weakness in capital goods output, in turn reflecting weaker demand from China and other Asian markets. EUR depreciation vs USD (-10% since early 2018) and on effective exchange rate basis, has not provided sufficient fillip as yet.

    In the face of weak data, the weight of further monetary easing is squarely on the European Central Bank. The Governing Council meets next week, where it will prefer to act pre-emptively to address low inflation and near-stagnation in growth. Apart from trade-related uncertainty, fallout from Italian political uncertainty and Brexit-led volatility will also keep policymakers on tenterhooks.

    A mix of easing measures is on the cards – dovish forward guidance, 10bp cut in the deposit facility rate (currently at -0.4%), introduction of a tiered deposit scheme, (which will turn) LTROIII on attractive terms and signals that asset purchases might resume later in the year. The Council is split on the prospect of resuming QE, with the hawks cautioning against turning hostage to market expectations.

    Decline in inflationary expectations pose doubts over the material impact of policy action. Overnight rates are pricing in 10-20bp cuts to the deposit rates, while bond spreads of Italy/France vs Bunds tighten, despite growth and fiscal troubles at home. As monetary policy hits its limits, pressure for fiscal support is likely to rise.

    Chang Wei Liang

    Credit & FX Strategist

    Radhika Rao

    Economist – India, Thailand & Eurozone

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