LCG: ECB could surprise amid seven-year low PMI read. Pound rebounds. Turkey decides.

July 25, 2019

European equity markets were mixed on Wednesday. The FTSE 100 (-0.73%) underperformed its European peers and closed a touch above the 7500p as mining stocks (-2.35%) and financials (-1.13%) led losses.

But softer British pound and better-than-expected earnings remain mouth-watering for British chip investors. Nearly a fourth of FTSE companies released results, and the latest earnings surprised on the upside by 18.54%. Though the expectations were low, and easy to beat, the global trade tensions and Brexit issues had a lower-than-anticipated impact on British company results. Hence, British equities remain juicy for investors.

FTSE futures hint at a positive start in London. Dip-buyers could take advantage of price declines below the 7500p level.

The pound jumped to 1.2522 against the US dollar, the euro-pound tested the 0.89-support, as capital inflows from euro to sterling intensified posterior to Conservatives’ vote results and ahead of the European Central Bank meeting.

Euro bears eye $1.10 mark, as ECB could surprise following a seven-year low PMI read

The European Central Bank (ECB) will deliver its latest monetary policy verdict today. Although European policymakers are expected to maintain the interest rates unchanged at today’s meeting, President Mario Draghi will likely deliver a dovish accompanying statement, as the ECB is faced with slowing economic activity, waning inflation expectations, topped up with souring Brexit negotiations. But there could be more in Draghi’s hat today. Released yesterday, Markit’s manufacturing PMI fell to a seven-year low in July, despite the rising dovish policy outlook. In the past, this low PMI reads have been followed by a surprise ECB action. The activity in Eurozone sovereign markets indicate that the probability of a 10-basis-point rate cut jumped to 54.2% at today’s meeting.

So, what will happen next is quite clear to everyone. The ECB will likely navigate through further negative territories in terms of policy rates and step up its asset purchases via another round of TLTRO (targeted long-term refinancing operation) hoping that additional easing measures would lift the inflation expectations more sustainably this time. Although there is no guarantee that more easing will bring back the consumer inflation, a surprise policy move could pull the euro down significantly and boost the expectations for a while.

The euro is under a decent selling pressure as downside risks prevail ahead of the ECB decision and Draghi’s press conference. The EURUSD tests the year-to-date support near the 1.11 mark, stops are eyed below this level. A dovish accompanying statement from Mario Draghi, or a surprise move could encourage a rapid euro sell-off to 1.10 mark or lower against the US dollar. Large put option expiry is also due at 1.1125 today. More expiries stand at 1.1075/1.1070.

On the upside, the EURUSD should move above the 1.1160 mark to see support from call options at today’s expiry.

Where did inflation go?

The waning consumer prices have left many wondering about where the inflation has gone. A deeper glance into the market hints that the decade-long ultra-dovish monetary policies have inflated real estate and financial asset prices in developed economies. Hence, the problem is partially structural. Consumers in developed countries have a lower spending-to-saving ratio. Therefore, the rise in inflation remains limited when the unemployment rate decreases. Combined with rigid jobs market, more-than-a-decade-long financial crisis, and low-to-negative interest rates, households have been moving capital to real estate and financial assets. This is where your inflation is.

Ceteris paribus, there is no reason for the current low-interest-rate-low-consumer-price-inflation trend to change. Yet central bankers don’t have optional policy tools in hand for the moment. So lower interest rates and more asset purchases it will be.

Reality check for Turkish Central Bank

The Central Bank of Turkey will meet today and is expected to lower its one-week repo rate under the lead of its new chief Murat Uysal.

A consensus of analysts anticipates 250-basis-point cut to 21.50% at today’s policy meeting. And in fact, the slowing inflationary pressures, the steady Turkish lira and the clear easing bias from the world’s major central banks are supportive of a rate action in Turkey, where the interest rates are relatively higher compared with similar emerging market rates.

The sudden change in CBT’s monetary policy committee suggests that the bank could unwind its interest rates in line with President Erdogan’s will, which would be significantly faster than what could be absorbed by the market. This far, lira traders have given Murat Uysal the benefit of doubt. But today is the reality check. We believe that Murat Uysal could opt for a 300-basis-point cut to mark the beginning of his reign at today’s meeting.

There lie the downside risks for the Turkish lira. A rate cut above 250-basis-point could trigger a sell-off in lira and lira-denominated assets, as it would signal a clear shift to a steeper dovish policy outlook. The key resistance to USDTRY’s steady trading range stands at 5.80, the 50-day moving average. A move above this level could trigger renewed lira headwinds and bring the 6.00 mark back on target.