The point of today’s article is to debate a little bit about the ECB meeting next week (March 6th) and what are policymakers’ options to counter a strong ‘Euro’ combined with low inflation.
1. The ‘Euro Strength Story’
However, let’s first review the few factors that have contributed, in our opinion, to the Euro strength over the past year. The first indicator we usually watch is the peripheral-core spreads, which determines the Euro zone risk and investors’ sentiment about the global outlook of the Euro area. To give you an idea, the Italian and Spanish 10-year yields are now trading at their multi-year lows (2006 levels) at 3.47% and 3.49%. Since the famous ‘Whatever it takes’ phrase pronounced by Mr. Draghi in July 2012 (27th) followed by the introduction of the OMT program one week later, the single currency has constantly been pushing up against the greenback as policymakers’ support brought back investors’ interests in the Euro zone. Below, there is a popular graph that we like to watch overlaid with EURUSD spot rate, the 3-year Spain-German yield spread. As you can see it, the narrower the spread (white line, inv. scale), the stronger the Euro (purple line)…
The second indicator that played in favour of the Euro strength was the divergence between the ECB and Fed’s Balance Sheet Total Assets. After the Fed announced its QE-4-Ever ($85bn monthly purchases) in the last quarter of the year 2012, the central bank’s balance sheet has constantly been surging since then, increasing the money supply and therefore impacting the value of the US Dollar. As you can see it on the table below, the Fed’s B/S expanded from $2.91tr in December 2012 to $4.15tr reported in mid-February this year, which represents a 42.6% increase. At the same time, the ECB, unlike the other major central banks, has largely refrained from using its money-creation powers and its assets holdings were reduced from €3.02bn to €2.19bn (-27.5%).
Source: Bloomberg; ECB (ECCSTOTA Index) and FED (FARBAST Index)
Therefore, below is another chart that we like to watch overlaid with EURUSD, the Fed-to-ECB Balance sheet ratio. As you can see it, the ratio (yellow line, inversed scale) is up from 0.9000 to 1.3783 over the past year, while EURUSD is up 8 figures down from 1.3000.
The last point that played a role in the ‘Euro strength story’ would be the big quarterly increases in the surplus of the EZ payments current account. Current account, which spots the difference between a nation’s savings and its investments, is an important indicator about an economy’s health. According to Eurostat, Euro Zone current account showed a surplus of 221.3bn Euros over the 12 months to December 2013, compared to a surplus of 128.6bn Euros a year earlier (surplus means basically that the Euro is a net creditor to the rest of the of the World).
After its low of 1.2040 reached on July 27th 2012, EURUSD is now trading around the 1.3800 level, which seems to be ‘uncomfortably too high’ for policymakers. Therefore, Draghi has now two issues, which are a low inflation rate combined with a ‘strong’ Euro. We saw last week that final annual EZ inflation edged up 0.1% to 0.8% in January, but still remains well below the ECB 2-percent target. Private loans have been contracting for twenty consecutive months (-2.2% in annual terms in January) and Money supply growth (M3) in the Euro still sits at low levels compared to the ECB’s 4.5% reference rate (+1.3% YoY in January).
In addition, the decline of the German CPI (Flash Feb eased to its lowest level in 3-1/2 years at 1.0% YoY in February, down from 1.2% YoY the previous month) is adding pressure to other countries of the Euro area, as they need to have a lower inflation than Germany in order to regain competitiveness.
2. The ECB’s options…
The market is talking about further easing, however it seems to me that Mr. Draghi is running out of options. Quantitative easing is out of the question as the Germans won’t approve it for the moment. Then, we believe that another LTRO (3rd one) wouldn’t be successful as banks are still stuck with the LTRO1 and 2 reimbursements. In addition, it may have a negative impact on the single currency in the short term (250 pips ‘correction’ two weeks following the first two announcements, however liquidity will continue to keep sovereign yields at multi-year low levels and therefore support the Euro). Eventually, there are market talks of negative deposit rate, but it seems to me like the ‘tool of the last resort’ and we believe the situation is not that critical yet. When we asked the question to Thomas Stolper (Chief FX Strategist at Goldman Sachs), he added that negative deposit rate is a dangerous tool: ‘there is a risk that banks actually pass negative carry on excess liquidity on to their clients, which is risky in the periphery where this could be counter-productive’.
The only option next Thursday remains a tight cut in the refi rate (probably 10 bps), which we believe is strongly priced in. Therefore, the lack of reaction from ECB policymakers could continue to push EURUSD to higher levels (1.4000 at first, Sep-2011 levels), and will also benefit (as we saw yesterday) from global equity flows (as they continue to favour inflows into Europe).