ECB prepares ground for asset purchases. But it's still talk

London: The euro gave up gains against the dollar on Thursday, after ECB President Mario Draghi once again flagged the risk of asset purchases to ward off deflation risks and said a rise in the euro could trigger policy action.

After two days of gains, the euro slipped to $1.3820 following Draghi’s comments, leaving it a tad firmer on the week. It had earlier risen to a session high of $1.38435 after an upbeat German IFO survey.

While stressing that the ECB sees inflation remaining low for a prolonged period before rising again, Draghi said the European Central Bank could embark on a broad-based asset buying plan if the euro zone inflation outlook worsens.

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Draghi also warned that a rise in the currency that effectively tightened monetary policy could trigger policy action, including a negative deposit rate. “The exchange rate is an increasingly important factor in our assessment of the outlook for price stability,” he said.

But traders said further euro losses were unlikely until the ECB backed up these words with action. The euro is also being supported by falling excess liquidity in the euro zone banking system, a factor that keeps overnight rates elevated and adds to the currency’s allure.

“Draghi’s speech did not add anything new, but amplifies the importance of next week’s inflation numbers,” said Jeremy Stretch, head of currency strategy at CIBC World Markets.

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“If inflation doesn’t jump as the ECB is expecting, it could be a catalyst for further action. Until then, we expect the euro to trade in ranges.”

Apart from signs of a recovery in the euro zone, as reflected in yesterday’s PMI surveys and Thursday’s IFO report, there have been a number of factors behind the euro’s strength. These include renewed inflows into euro zone peripheral bonds and stocks and the fact that euro zone banks are repaying the ECB’s cheap loans, shrinking its balance sheet at a time when the Federal Reserve and the Bank of Japan are expanding theirs.

Many euro zone banks have meanwhile been cutting their presence abroad, selling assets and repatriating money to meet capital and stress test requirements. These inflows allow the euro zone to maintain a healthy current account surplus and support the common currency.

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Implied volatilities in the euro/dollar pair have also fallen to levels last seen in mid-2007, highlighting expectations that the currency is likely to trade in a range.

A drop in implied volatility, which is a gauge of how sharp swings in a currency will be, is likely to underpin demand for riskier and growth-linked currencies, analysts said.

The higher-yielding New Zealand dollar climbed to a one-week high of $0.8638 after the country’s central bank said it would continue to tighten policy to stay on top of inflationary pressures. As expected, it hiked its cash rate to 3.0 percent from 2.75 percent.

“Currencies that are likely to benefit in this environment (of low volatility) are the ‘fragile five’ emerging market currencies, and the New Zealand dollar in the G10,” said David Bloom, global head of FX strategy at HSBC.

The ‘fragile five’ are the Turkish lira, the South African rand, the Brazilian real, the Indonesian rupiah and the Indian rupee.

The safe-haven yen rose against the dollar as Tokyo shares fell nearly 1 percent .N225, after Japanese Prime Minister Shinzo Abe said that a trade deal with the United States had not been finalized yet.

Mollifying Japan’s powerful farming lobby and completing a successful trade pact is seen as a key test of whether Abe can deliver the “third arrow” - structural reform - to go with fiscal and monetary stimulus measures already deployed.

The dollar last fetched 102.41 yen, down 0.1 percent.

Reuters