All eyes on ECB and EURUSD

EURUSD remains under pressure is now trading below its 200-day SMA (1.3640) at around 1.3600 after disappointing German employment and EZ data weighed on the single currency yesterday morning. ECB data showed that lending to households and firms in the Euro zone declined further in April by 1.8% from the same month one year after a contraction of 2.2% in March.
Moreover, the annual growth of M3 (money aggregate, definition here) declined strongly to stand at 0.8% (from 1.1% in March and vs. expectations of 1.1%) and stands well below the ECB’s target of 4.5% as you can see it on the graph below (which represents the historical path of M3 money aggregate in yellow and annual inflation in green since 2003).


(Source: Reuters)

Why is M3 important? If we have a look at one the ECB’s earliest Press Releases (December 1st, 1998) – The quantitative reference value for monetary growth – it stated that the Governing Council of the ECB agreed then on some details of the reference value:

  • ‘it will refer to the broad monetary aggregate M3’
  • ‘Governing Council decided to set the first reference value at 4.5%’

The graph above shows us that there is a relationship between inflation and M3 growth, therefore we could see still see a weak annual inflation next week on June 3rd (expected to come in at 0.7%). In addition, the HCIP (Harmonized Index of Consumer Prices, which enables international comparisons of inflation rates to be made between member states within the EU) of the core – ‘healthy’ – countries stand currently at very low levels. For instance, Germany HICP came in at 1.1% in April, up from 0.9% the previous month but down from 2.9% in August 2011. And in order to regain competitiveness, the peripheral ‘stressed’ countries are required to show a lower inflation than the core ones, which increase the risk of deflation (Spanish and Italian annual inflation stand at 0.3% and 0.6% respectively, while Greece and Portugal are already facing deflation).

ECB’s option at next meeting: All-in or non-event?

From now on, traders and investors will be focused on one of the most important events of the year: the ECB meeting on June 5th. After Draghi announced in his last press conference in Brussels that the ECB officials were ready to act at the next meeting, the question is now ‘what are the options?’ While a cut in the refi rate (10-15bps) is largely priced in by the market and will have little or no impact on both the Euro and the inflation rate, could it come with a cut in Deposit rate (which currently stands at 0%) and/or an asset-purchase program?

The effect of a negative deposit rate (10 bps cut), which means that ECB would charge banks for parking their money at the central bank rather than lending it, remains pretty much obscure and not the best option to encourage banks to lend more. It could potentially weigh on the single currency in the short term, which isn’t the ECB officials main objective (As a reminder, ECB’s Forum on Central Banking in Portugal, Draghi said: ‘What we need to be particularly watchful for at the moment is, in our view, the potential for a negative spiral to take hold between low inflation, falling inflation expectations and credit, in particular in stressed countries’).

Therefore, if we see an action, it will probably combine a refi rate cut with an unconventional measure according to some analysts. There are several monetary policy instruments that the ECB can apply in times of extraordinary market tensions, from a full-allotment of liquidity provision (fixed rate) to a longer-term liquidity provision (LTRO) or private/public QE.

Firstly, the fixed-rate full allotment, which allow stressed banks to access unlimited ECB liquidity at a fixed rate in return for collateral, will probably be extended (until this summer at least) and would leave the marginal lending facility, an overnight lending scheme that charges a premium interest rate, useless.

Second, we don’t think it is an appropriate time to launch a third LTRO as banks are still stuck with the first two repayments. Moreover, we saw previously that the LTRO has a positive impact on the Euro in the long-term. Liquidity will continue to drive sovereign yields lower and will tend to push the single currency at higher levels even though the Euro hasn’t been reacting to tightening spreads between periphery/core countries since Draghi’s press conference. Since July 2012, the 3-year spread Germany-Spain has tightened drastically and was one of main drivers of the Euro’s strength.

The third option is either a public or a private QE. A private quantitative easing would involve the purchases of private sectors assets, which could include asset-backed securities or bank bonds; rather than a public QE will include government bonds purchases (sovereign, ESM…). To me, these two options sound too much like a ‘whatever it takes to counter a strong Euro’, and we will repeat ourself by saying that ‘kill the Euro’ is not the core objective at the next meeting.

Quick analysis on EURUSD:

The pair found support slightly above 1.3580 and saw some bounce in Asia due to some short covering and saw technical ‘bull’ rebound after the RSI indicator was showing us an oversold signal. The resistance on the topside stands at 1.3641 (200-day SMA in blue), where we will start to see offers if the Euro continues to recover. The trend still looks a bit bearish at the moment, with 1.3520/40 as the next support area.


(Source: Reuters)

The Euro Strength and the ECB’s options

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)…

(Source: Bloomberg)

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.

(Source: Bloomberg)

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).