One day before the ECB's infamous disappointment last Thursday, Goldman's chief FX strategist Robin Brooks opined as follows: "it remains the case that downside skew in EUR/$ is modest compared to the run-up to the Jan. 22 meeting. In short, we think risk-reward to short EUR/$ into tomorrow’s meeting remains compelling and we anticipate a 2-3 big figure drop on the day."
The result is by now well-known to everyone - there was a 4-5 big figure move, only it was higher, as countless Goldman clients lost their shirts, and prompted the following mea culpa hours later: "The Euro rallied, driven by declining inflation break-evens and rising nominal yields, i.e., rising real yields. This price action has all the hallmarks of the Yen under Governor Shirakawa, as opposed to Governor Kuroda, raising for us the unpleasant possibility that the idiosyncratic Euro weaker story has been compromised. Even in the unlikely event that today’s disappointment was a mistake, we think it has cost enough credibility that the Euro down story we had envisaged is now less likely to play out. We are placing our forecasts under review."
Then, one day later, Draghi explained the "disappointment" was indeed a mistake, and the EUR proceeded to slide 150 pips from intraday highs just shy of 1.10.
And then overnight, Goldman concluded its "review" of where the EUR will go in the short, medium and long-term, when Robin Brooks announced Goldman is now "Scaling Back our Expectation for Euro Downside" specifically saying the firm revises its forecast for EUR/$ to 1.07, 1.05 and 1.00 in 3, 6 and 12 months (from 1.02, 1.00 and 0.95 previously) and lifts its year end-2017 forecast to 0.90 from 0.80. To wit:
In our eyes, the Euro lower trade has always been about regime change at the ECB, a shift from Bundesbank-dominated thinking towards reflationary policies aimed at confronting low inflation in Europe. With inflation trending lower, this shift had been under way for some time and grew in intensity in 2014, in the run-up to the QE announcement in January of this year. However, shortly after the start of ECB QE, a discussion over “tapering” and a sharp rise in Bund yields began to undermine the program, causing the Euro downtrend to be arrested.
During that period, our view of fundamentals was such that we stuck to our forecasts. We wrote about how structural reforms on the periphery were likely to keep inflation in Europe lower than otherwise, given that product and labor market reforms could be shifting the Euro zone Phillips curve down. Our view was essentially that, with this inflation dynamic under way, the doves on the Governing Council would be able to reassert themselves, allowing them to consolidate the ECB QE program and fix some of the damage from the summer.
That is not what happened last week. Of course, the ECB did provide additional stimulus, in the form of another deposit cut and an extension of the QE program. It is also possible that thin liquidity exaggerated market moves, such that the spike in EUR/$ overstates the degree of disappointment to the market. But in the end, what mattered last week was whether the ECB sent a message consistent with President Draghi’s speech in Frankfurt on November 20, one that signalled a sense of urgency over the need to confront low inflation. It did not.
Our best read is that the Governing Council is conflicted over the use of unconventional policies and therefore resisted more aggressive action. Given that – at the zero lower bound – so much rides on a central bank’s willingness to send strong signals in order to influence expectations, last week’s performance likely compounded the damage from the summer, rather than fixing it. In short, our conviction in regime change is down, and we worry that the ECB is starting to lag relative to the BoJ under Governor Kuroda.
As a result, we are scaling back our expectation for Euro downside. We revise our forecast for EUR/$ to 1.07, 1.05 and 1.00 in 3, 6 and 12 months (from 1.02, 1.00 and 0.95 previously) and lift our end-2017 forecast to 0.90 from 0.80. We also reduce our expectation for Euro downside against the Pound, where our EUR/GBP forecast is now 0.71, 0.70 and 0.68 on a 3-, 6- and 12-month horizon (from 0.69, 0.67 and 0.65 before). Our end-2017 forecast is now 0.65 versus 0.57 previously. Finally, we revise our EUR/CHF forecast to be essentially flat on a 12-month horizon, with an end-point of 1.15 in 2017 (from 1.10 before).
On a trade-weighted basis, these forecast revisions mean that Dollar appreciation against the majors through end-2017 is now 14 percent, down from 20 percent previously. We are still firmly in the Dollar bull camp, therefore, continuing to see Fed lift-off and subsequent tightening as USD positives, as we laid out in the FX Analyst in April 2014.
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