Regional FX Strategy: ECB Risks Disappointing Markets

We see a material risk that the European Central Bank (ECB)'s actions on June 5 will disappoint markets, weakening Emerging European FX against the euro. Volatility in regional FX markets has dwindled ahead of the ECB's June 5 meeting as markets wait to see whether monetary policy becomes markedly more dovish to ward off the deflationary threat. Most market participants are predicting the ECB will act, although there is a wide variance of expectations about the specific policies. Since the May 8 ECB press conference, only the Czech Koruna (-0.2%) lost ground against the euro due to the ceiling on the exchange rate, while Emerging Europe FX such as PLN (+1.1%), RON (+0.7%), HUF (+0.2%) and TRY (+1.4%) all experienced gains. RUB (+2.1%) also made strong gains, although this can be partly attributed to de-escalation of military tensions with Ukraine after Russian troops began pulling back from the border.

Underpinning this recent softening in the euro are increasingly optimistic market expectations for ECB action. However, we expect that the ECB to avoid policies that would have the largest impact, such as outright quantitative easing ( see 'Crunch Time For The ECB: A Policy Primer', 30 May 2014). Our view is for a cut to the refinancing rate by 10 basis points (bps) at the June meeting, with a high probability of a 10bps cut to the deposit rate. This is broadly in line with the minimum action that the market anticipates and hence would be unlikely to drive regional FX much higher against the euro. On the contrary, there is a material risk that the limited scope of the ECB's action could disappoint market participants, pushing the euro higher against regional pairs.

If the ECB opts to go beyond refi and depo cuts, perhaps including the suspension of SMP sterilisation, ABS purchases and/or targeted LTRO, this would likely be more effective in weakening the euro, and we would expect to see major regional currency pairs gain. At the same time, we note that tolerance for stronger currencies in emerging Europe varies substantially, and gains would ultimately prompt regional central banks to adopt looser monetary policy stances, limiting potential gains.

Awaiting Clarity On June 5 Decision
Exchange Rate - PLN/EUR, daily

Regional FX Strategy: ECB Risks Disappointing Markets

We see a material risk that the European Central Bank (ECB)'s actions on June 5 will disappoint markets, weakening Emerging European FX against the euro. Volatility in regional FX markets has dwindled ahead of the ECB's June 5 meeting as markets wait to see whether monetary policy becomes markedly more dovish to ward off the deflationary threat. Most market participants are predicting the ECB will act, although there is a wide variance of expectations about the specific policies. Since the May 8 ECB press conference, only the Czech Koruna (-0.2%) lost ground against the euro due to the ceiling on the exchange rate, while Emerging Europe FX such as PLN (+1.1%), RON (+0.7%), HUF (+0.2%) and TRY (+1.4%) all experienced gains. RUB (+2.1%) also made strong gains, although this can be partly attributed to de-escalation of military tensions with Ukraine after Russian troops began pulling back from the border.

Awaiting Clarity On June 5 Decision
Exchange Rate - PLN/EUR, daily

Underpinning this recent softening in the euro are increasingly optimistic market expectations for ECB action. However, we expect that the ECB to avoid policies that would have the largest impact, such as outright quantitative easing ( see 'Crunch Time For The ECB: A Policy Primer', 30 May 2014). Our view is for a cut to the refinancing rate by 10 basis points (bps) at the June meeting, with a high probability of a 10bps cut to the deposit rate. This is broadly in line with the minimum action that the market anticipates and hence would be unlikely to drive regional FX much higher against the euro. On the contrary, there is a material risk that the limited scope of the ECB's action could disappoint market participants, pushing the euro higher against regional pairs.

If the ECB opts to go beyond refi and depo cuts, perhaps including the suspension of SMP sterilisation, ABS purchases and/or targeted LTRO, this would likely be more effective in weakening the euro, and we would expect to see major regional currency pairs gain. At the same time, we note that tolerance for stronger currencies in emerging Europe varies substantially, and gains would ultimately prompt regional central banks to adopt looser monetary policy stances, limiting potential gains.

BMI Europe Asset Class Strategy
DATE INITIATED ENTRY LEVEL GAIN/(LOSS) RATIONALE
CURRENCIES
Bullish TRY vs RUB 18-Mar-2014 16.4 1.6% Turkey offers a more attractive long-term investment story and positive carry, while lower oil prices will expose Russia's massive economic challenges.
Bullish RON vs EUR 27-May-2014 4.40 0.1% The healthy carry offered by Romanian local debt, an attractive technical picture and robust exports.
FIXED INCOME
NA
EQUITY INDICES
Eurozone Over US Equities (Ratio of MSCI US to MSCI EMU) 15-Aug-2013 17.3 1.0% Though we still like the US, eurozone underperformance has reached extremes, and the eurozone economy is picking up momentum. The MSCI EMU looks attractive on a technical basis and is increasingly cheap versus the US. Targeting a move down in the US/EMU ratio to 14.0x.
Bullish Italian FTSE MIB Index 28-Mar-2014 21,345.5 1.7% Constructive technicals, positive political developments and low relative valuations.
MACRO/INDUSTRY STRATEGY
NA
NA = not applicable. Source: Bloomberg, BMI
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