In our past January 19th article “Where is euro going next“, we explain the negative correlation between asset volatility and the euro. When stock market declines, the euro/dollar goes up, and vice versa. The table below from Morgan Stanley (NYSE:MS) confirms this inverse relationship. We can see that other than the period between 2007 – 2009 and the period in 2011, this negative correlation between the euro and risky assets remains true.
Since the peak in 2015, global indices have corrected in double digit figures. Below is global indices correction from 2015 peak to 2016 low as of March 1, 2016:
Despite the already substantial correction, looking at the world indices, it’s likely that the correction is not yet over. Below we take a look at two indices, Shanghai Composite Index and FTSE, to make a case that the correction is not over:
Weekly chart of Shanghai Composite Index above is showing an incomplete 5-swing sequence from 2015 peak, and more downside is expected at least towards 1944 – 2370 area in the higher degree time frame.
The weekly FTSE chart above is also showing a 5-swing sequence. Please note 5-swing is a sequence count, and it is not Elliottwave 5 impulse waves.
ECB Meeting in March 10 is a possible key event for next market move
In December last year, ECB disappointed the market by merely cutting deposit rate by 25 bps and extending QE program by six months until March 2017. Market was expecting the ECB to expand the Quantitative Easing program, but ECB did not deliver. The euro rallied strongly as a reaction at that time. Since then, headline inflation in the euro area has continued to dip lower, and latest euro inflation rate report in February 29 shows a -0.2% yoy.
As expected, the energy component is the major drag, with an 8% fall. However, euro core rate (excluding energy, food, alcohol, and tobacco) also slowed down to 0.7% compared to 1% in the previous month.
This number is far below ECB’s 2% target and gives pressure to ECB to act more in the next coming meeting at March 10. ECB President Mario Draghi has said at the bank’s latest monetary policy meeting in January that ECB will review and possibly reconsider the stimulus program at the March’s meeting. He also said that ECB will not hesitate to act if necessary.
Market interprets his statement that more easing is likely in March and currently market has somewhat priced in a further deposit rate cut by ECB, as evidenced by the steady decline in euro dollar since February. The recent stabilization of risk asset and rally in indices in some ways also reflects the expectation that ECB might ease further.
We have seen that cutting rate (e.g. BOJ going to negative rates in January) does not really push the currency lower. In the case of BOJ, despite cutting deposit rate into negative territory, the yen selloff is a temporary reaction, and it rallied sharply afterwards. Thus, even if ECB cut deposit rate by 25 bps at the next meeting, then using the example of BOJ, euro is likely not going to go lower significantly.
The big unknown, however, is whether ECB will expand the QE program at March’s meeting. Germany has consistently opposed the idea of expanding the QE program, and while ECB might be willing to expand, they currently face the problem of limited eligible bonds to buy. The ECB has a rule that it can’t buy any bond that yields less than its current deposit rate, which is minus 0.3%. Using this rule, 50% of German’s debt is no longer eligible for the ECB’s QE progam, as they fall below the -0.3% yields. German two-year yields for example touched -0.57% on February 29, thus making it ineligible under the ECB’s QE program.
Should the ECB decide NOT to expand the QE program at the coming March meeting, then a similar reaction (euro/dollar rally) may happen like the one we saw in December last year. Due to the inverse correlation with indices, then without QE expansion, it can also mean a turning point in indices for the next leg lower. Chart below shows reaction of three euro pairs in December’s meeting when ECB decided not to expand the QE program.
