EUR Longs Have Few Places To Hide

Euro flash prices hit negative territory

Euro CPI headline and core diverge on energy

German unemployment data improves sharply

EUR breaks psychological €1.1860

Investors are only interested in one number this morning and that’s the Euro flash Consumer Price Index. Would it fall into negative territory for the first time in 5-years? And if so, would it bolster market expectations of a more aggressive policy response from the ECB? It has and not necessarily so.

As expected, consumer prices fell on an annual basis in December for the first time since the depth of the financial crisis. The headline print came in weaker than forecasted with a reading of -0.2% y/y, compared to expectations for -0.1% and +0.3% in November. The core rate has actually moved higher to +0.8% y/y, compared to +0.7% previously. The results will complicate things a little, but the headline rate is likely to be used to justify ECB initiating QE even if much of the decline seems to be attributed to volatile factors.

Sustainable lower prices tend to have a far-reaching negative impact on an economy. Eventually, it will only compound the Eurozone’s problems of weak output growth, high unemployment and falling business investment. Falling consumer prices make it tough for households, governments and corporations to repay their debts, which currently sit atop of record highs. They may even pressure consumers and businesses to postpone future consumption and investment. The spiraling and knock on effect could raise unemployment, stunt any economic growth and push prices even lower.

ECB: What to do?

The market now looks to the ECB for a response. All along, Draghi and company have indicated that they will respond to the latest weakening in the inflation outlook with fresh stimulus measures that “could” include purchases of sovereign government bonds. In the spirit of transparency, the Central Bank President said last month that the bank is making “technical preparations” to alter the size, pace and composition of its stimulus program.

A percentage of the market will interpret this morning’s data that it’s no longer “if” the ECB will announce QE on January 22, but “how” will it be tailored and this despite the rate of inflation been driven by a sharp fall in energy prices. Energy prices fell -6.3% last year, while prices of other goods and services were still +0.6% higher than a year earlier, but well below the ECB’s desired inflation target of +2%.

The ECB has a number of tough questions to ask and answer before acting. If energy is the culprit, should the ECB rush to provide further stimulus? Lower energy prices could boost consumer discretionary income and eventually consumption. Are a couple of months of negative pricing a serious trend that defines “deflation”? Not necessarily so, one needs to throw in declines in GDP and wage before deflation can be said to taking a firm grip.

Market interprets an ECB plan

The market is reporting that the ECB is eyeing three possible outcomes for QE on Jan 22:

Buy government bonds on capital keys

Only buy AAA rated paper including loans, and

National Central Bank’s buy their country government bonds based on capital keys

If true, then the QE debate can be interpreted as shifting towards QE modalities with the ECB eager to show that QE is “not” adding credit risk by getting NCB’s to hold the risk. The final result could end up being an “uneasy” compromise on criteria, terms and magnitude of Eurozone government bond purchases.

Draghi will not want to, nor can he afford to disappoint the market. Any weakness from the Central Banks perspective will be pounced on by the market, which will only have a spiraling negative impact. Ideally, the easier solution for the ECB would be an end to austerity rather than implementing modified QE – In a utopia world; Draghi and company require a fiscal policy to work better with monetary policy to promote investment and growth. Not about to happen with such an eclectic bunch of economies.

A Diverging Job Market

This morning’s Eurozone job data shows the divergence of economies within the region. German unemployment at +6.5% in December is at a record low while Italian unemployment at +13.4% is at a record high. A small plus for the ECB is that unemployment fell sharply in Germany for December (-27k), which would suggest that consumer spending should support activity in Europe’s largest economy. For investors, it seems that Italy, and other periphery economies will have to wait for the ECB and its next phase of monetary stimulus before the market can see a change to growth, investment and inflation for the less robust economies. The event risk for the ECB’s January 22 meeting is whether Draghi will stand and deliver what the market expects.

Long EUR positions cannot hide

This morning’s CPI has the 19-member single currency on the move again, albeit at a snail’s pace lower to a nine-year low (€1.1845). The single unit has lost -1.9% year-to-date (less than a week), even hitting many Q3 and Q4 forecasts. Being short EUR’s is a profitable, crowded trade and also somewhat tired. Most of the positions have been piled into since after the holidays. Investors and dealers do expect more downside movement over the coming weeks as investors continue to price in sovereign QE, a Grexit and Russian risks. Uptick moves thus far have been very limited. Current future EUR shorts are still -15% below last year’s peak and -30% below the 2012 record. Now that the market has broken through €1.1860 after the CPI print, should open the way for the January and February lows of 2006 (€1.1800 and €1.1826) to be tested.