What the Heck is Draghi Smoking?

Is Mario Draghi losing it? After all, despite all the lowered expectations and poor data coming from the euro, Draghi insists that we’re gonna see a comeback in late 2013.

I find his stance a little bit curious, as the ECB actually lowered its growth expectations for 2013, and is now predicting GDP growth to clock in at around -0.5%, down from initial forecasts of -0.3%. That’s right, the central bank as a whole believes that the euro zone will most likely contract at the end of the year!

Recent data hasn’t been encouraging as well.

The euro zone purchasing manager indexes have been soft, with the manufacturing and services editions printing below the line-in-the-sand 50.0 mark, indicating contraction in those industries.

Meanwhile, recent GDP figures show that Germany, France, and Spain – supposedly the heavy hitters of the euro zone – all contracted last quarter. If these big shots are struggling to gain any momentum, then what can we expect from peripheral nations?

Let’s also not forget the recently concluded Italian elections. With the government stuck in a stalemate, there’s absolutely no telling what will happen. Heck, we may even see Berlusconi re-enter office!

These are all signs of trouble for the euro zone, and it’s no wonder that the ECB Governing Council actually considered cutting rates at its last meeting. For now, the Council believes that the current rate of 0.75% will do, but this is definitely something to keep an eye on.

So we’ve got soft PMIs, no signs of momentum anywhere, and the threat of political instability. Why the heck was Draghi still so optimistic during the last ECB rate statement?

In my opinion, Draghi had no choice but to at least try and sound upbeat. After all, it’s part of his job to communicate to manage market expectations. If Draghi had come out with a negative tone on top of the lowered growth expectations, he would have risked rattling the markets and adding fuel to the recent uneasiness surrounding the euro zone.

Instead, he did his job and expressed the stance of the ECB, which is that it is open to more lowering rates but only if we see continued weakness from the euro zone. The fact that he was optimistic about a turnaround later this year signals that he’s hoping that current measures will be enough to jump start the euro zone.

In any case, the markets responded positively to Draghi’s speech, allowing it to rise versus the dollar last Thursday.

EUR/USD Chart

The question is, will the sentiment continue or will it be short-lived?

Currently, EUR/USD is trading around the 1.3000 to 1.3100 area, which has been a crucial area of interest in the past. Should the markets feel that a rate cut is coming, we could see EUR/USD drop back down below 1.3000 and possibly head all the way down to November’s lows around 1.2700.

On the flip side, if Draghi continues to express optimism and we actually see some improvements in the economy, the euro bulls might come back to re-establish their long positions and see EUR/USD rise back up to highs around 1.3700.

In any case, make sure you pay attention to central bank rhetoric and speeches by Draghi, as it may prove to be the major driver for the euro dollar over the next few months.