Euro bears have thrown in the towel, with EURUSD squeezed to year-highs after the European Central Bank chief, Mario Draghi, delivered what the market has taken to be a more hawkish-than-expected assessment of monetary policy in a speech this week.

Taper talk is now voluble – markets seem to be betting the ECB will start to tighten or least remove some accommodation.

But were the remarks all that hawkish? Draghi had only a day before defended ultra-loose monetary policy and said premature tightening could risk another recession. The ECB has just downgraded its inflation outlook for the bloc.

Draghi did suggest inflation is becoming more sustainable and deflationary forces have been replaced by reflationary forces. Importantly he argued that deflationary forces are external, temporary shocks and the ECB can overlook. That’s what happens when you open the taps on a massive stimulus programme. The question is whether the Eurozone would survive without the QE support.

Draghi sounded more circumspect on that front, arguing that he is confident that monetary policy is working but still needs to remain very loose. Again it’s a stretch to describe the speech as hawkish – Draghi is simply affirming that loose monetary policy is working without significant adverse consequences and therefore should be maintained. He’s not advocating tightening any time soon.

Persistence is required, he argues, noting that “a considerable degree of monetary accommodation is still needed for inflation dynamics to become durable and self-sustaining”. The substitution of “considerable” for “very substantial” was seen as hawkish. Summer silly season has begun.

Draghi stressed that the Eurozone faces “a situation of continuing slack, and where a long period of subpar inflation translates into a slower return of inflation to our objective”. The result: “Inflation dynamics are not yet durable and self-sustaining.” Monetary policy has to stay easy.

It is true that the ECB is facing some political pressure from some to normalise policy sooner rather than later. But the arch-dove Draghi is unwilling to oblige since inflation remains patchy.

CPI in the euro area has failed to take off. The closely-watched core number cannot reach escape velocity. In May the core CPI fell to 0.9% from 1.2% in April. The lack of inflation is critical.

For the euro, Friday’s CPI flash estimates for the Eurozone will be make-or-break time. It should confirm the recent breakout or mark a phased withdrawal for the bulls.

Meanwhile the Federal Reserve is pressing ahead with more tightening. The euro is rallying against a dynamic of interest rate divergence that seems at odds with normal trends. The Fed is hiking, while the ECB shows no signs of tightening.

On this assessment the market is making a mistake. But for many it’s the Fed that risks making an error by tightening too quickly. The flattening of the US yield curve is a major concern. The front end of the curve is propped up by Fed rate hikes as this is the most sensitive to changes to the federal funds rate. The long end of the curve, in contrast, is pretty depressed. This trend is one of the best indicators of a recession and the more it flattens the greater the market will take note.

That perhaps is what is fuelling dollar selling as markets bet against the Fed. The dollar index is now back to where it was last October. Prospects of tax reform boosting growth have receded and US ten-year yields have retreated. The US reflation trade looks over.

Bond markets suggest the US is heading for weaker growth. The IMF agrees, revising down its forecasts for the world’s largest economy. Euro growth is improving and the ECB has upped its estimates for GDP.  On this basis, selling the dollar against the euro makes greater sense, not just because Mario Draghi uses slightly different words to express the same opinions.



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