EUR: ECB normalisation sequence matters - Nomura

Analysts at Nomura explain that ECB policy normalisation will likely be an important theme in FX markets later this year, after the French elections.

Key Quotes

“Although core members of the ECB are cautious about a core inflation recovery, macroeconomic fundamentals are clearly recovering. The speed and process normalisation will likely determine the magnitude of the EUR recovery. We estimate early rate hikes would likely strengthen EUR more significantly against USD via bear flattening of the curve.”

“Flattening appreciates EUR more broadly

Our estimate shows that if the ECB hikes rates before tapering (yield curve bear flattening) EUR should appreciate against most G10 currencies more significantly than if the ECB simply tapers its purchases (yield curve bear steepening). The exceptions in the G10 FX space are JPY, NZD and NOK, while JPY’s more negative sensitivity to EUR curve bear steepening is especially notable. Our previous analysis on G10 FX sensitivity to the G4 yield curve showed that JPY tends to weaken when long and super-long yields rise globally, and our estimated greater JPY reaction to EUR curve steepening is consistent with this would weaken USD, GBP and CAD. European G10 currencies, such as CHF, NOK and SEK, tend to react less to higher EUR yields under both scenarios, which is also reasonable as the economies are likely influenced by euro area economic developments.”

“ECB communication will be important to calm risk sentiment

The results show that the reaction of risk sentiment to monetary policy normalisation is important for high-yielding G10 FX and EM FX. High-yielding currencies tend to depreciate against EUR when EUR implied volatility rises and when European equity prices decline. They also tend to react more negatively to increases in USD implied volatility and US equity price declines. A “taper tantrum” in May 2013 came as a surprise to the market, leading to higher volatility and lower equity prices, weakening high-yielding G10 and EM currencies more, even though EM currency sensitivities to long and super long term US yields are estimated to be not so negative.

Thus, ECB tapering and likely rises in long-term EUR yields may not substantially weaken EM currencies against EUR if risk sentiment is resilient. The ECB’s communication strategy will be important. Surprise early rate hikes could be more harmful for these currencies if ECB communication is erratic and risk sentiment is badly hit. Earlier rate hikes could reduce market confidence in the ECB’s forward guidance, which could also amplify EUR appreciation.”