UBS House View Daily

Thought of the day

21.07 - Understanding the EURUSD reaction function

Mario Draghi’s commentary following the ECB's 20 July meeting included dovish-sounding statements, including the continuing need for “very substantial” monetary accommodation, and failed to set a time frame for tapering. Bond markets reacted accordingly, with 10-year yields falling across Spanish (–8.4bps), Italian (–7.1bps) and Portuguese (–4.6bps) bonds.

But the currency market responded as if Draghi's comments were hawkish. The euro climbed to a 23-month high of 1.1655 against the dollar.

We see three main reasons for the EURUSD’s apparently contrary reaction:

  • Draghi mentioned that the euro’s rally had “received some attention,” but declined to say it had moved too far, too fast. This suggests that further euro strength is not yet likely to be challenged by the ECB.
  • Markets are acknowledging that the ECB is running out of room to buy bonds indefinitely, with the Asset Purchase Program close to hitting its 33% ceiling on holdings of any government bond market. The increasing "shortage" of bonds could explain the fall in yields, while the prospect of the ECB hitting its "upper limit" might explain the rally in the euro.
  • On the other side of the trade, the US dollar has come under sustained pressure following weaker US inflation and fading hopes of fiscal stimulus from the Trump administration.

So, while Draghi’s generally dovish commentary supports our overweight in Eurozone equities and our expectation that the recent bond market sell-off won't go much further, the euro's upward move boosts our confidence that its rally is built on solid footing. The EURUSD has now met our three-month target of 1.16, but we aim for a further rise to 1.20 over 12 months.

Chart of the day

Understanding the EURUSD reaction function

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