Euro Strength Unsettling The ECB

Short-Term Outlook:

Having dropped sharply after hitting a two-year high of US$1.38/EUR at the end of October, the euro is once again back on the upswing and is currently trading at US$1.35/EUR. We reiterate our view from the beginning of the year: the combination of passive monetary tightening (as a result of banks repaying LTRO loans) and an improvement in investor sentiment as the crisis shifts from the acute to chronic phase, will provide fundamental support to the euro. Even the slowdown in eurozone economic growth during the third quarter and murmurings of potential unorthodox monetary policy easing has been unable to curb euro strength in recent weeks. In the absence of another surprise monetary policy intervention in the coming months, we would expect the euro to hold up heading into 2014.

Core View:

Euro Still Holding Up
Eurozone - Euro Index & US$/EUR

Euro Strength Unsettling The ECB

Eurozone Currency Forecast
Spot 2014 2015
US$/EUR, ave 1.35 1.27 1.23
EUR/GBP, ave 1.20 1.28 1.34
Policy Rate, % 0.25 0.25 0.25
Source: BMI, Bloomberg, 25 November 2013

Short-Term Outlook:

Having dropped sharply after hitting a two-year high of US$1.38/EUR at the end of October, the euro is once again back on the upswing and is currently trading at US$1.35/EUR. We reiterate our view from the beginning of the year: the combination of passive monetary tightening (as a result of banks repaying LTRO loans) and an improvement in investor sentiment as the crisis shifts from the acute to chronic phase, will provide fundamental support to the euro. Even the slowdown in eurozone economic growth during the third quarter and murmurings of potential unorthodox monetary policy easing has been unable to curb euro strength in recent weeks. In the absence of another surprise monetary policy intervention in the coming months, we would expect the euro to hold up heading into 2014.

Euro Still Holding Up
Eurozone - Euro Index & US$/EUR

Core View:

We stress, however, that policymakers are becoming increasingly unsettled by the stubbornly strong euro, which is reflective of other pernicious macro dynamics: namely an inappropriately tight monetary policy and incipient threat of deflation. Given the European Central Bank's restrictive mandate, unorthodox policy measures can only be justified on the basis that the price stability target is at risk of being violated, or that systemic stability is under threat. As such, with the eurozone recovery struggling to find momentum and fears of deflationary expectations emerging, the ECB is likely to intervene significantly in 2014 and will justify its actions by citing risks to price stability and the integrity of the financial system.

Broadly speaking there are five interrelated areas of concern: weak growth, a strong euro, high unemployment, deflation risks and a potential LTRO cliff. The eurozone economy expanded by just 0.1% q-o-q during the third quarter, down from 0.3% in Q213 and was held back by continued recession in Spain and Italy as well as a surprise contraction in French GDP. Given that we had expected to see the recovery pick up speed during H213 as private sector confidence recovers from the financial market turmoil of 2012, the most recent data provides significant cause for concern. Indeed, in the absence of a recovery in private sector demand to trigger a more virtuous broad-based economic expansion, the eurozone is at risk of sliding back into recession. Although the ECB is not in the business of aggregate demand management (the ideological foundations of the central bank are at odds with this premise), it is the only euro area institution that has the ability to intervene and provide the economy with a shot in the arm. Indeed, with politicians still struggling to agree on much-needed structural reforms to ensure the long-term survival of the euro, there is little hope of a near-term improvement in economic policy at either the national or federal level. Intrinsic to the need to boost growth, the ECB is fully aware of the damage that has been wrought to the economy by the destructively high unemployment rate, particularly for the younger segments of the labour market. Again, while this will not feature as an explicit policy objective (as has recently become the case in the US and UK), the central bank will nonetheless have a keen eye on unemployment when it loosens policy in 2014.

The biggest concerns that will be explicitly referenced when loosening monetary policy will be risks of deflation emerging and a so-called LTRO funding cliff. The shock drop in euro area inflation to 0.7% y-o-y in October from 1.1% in September has ignited fears that the eurozone is at risk of sliding into deflation. In the years following the global financial crisis, central banks have repeatedly shown a willingness to tolerate risks of higher long-term inflation, rather than suffer at the hands of deflation. The Japanese experience suggests that policymakers must act and swiftly and resolutely to ward off the threat of deflation. A failure to do so can allow deflationary expectations to become entrenched, at which it point it is far harder to generate positive inflation. The eurozone is already in a precarious position given the enormous public and private sector debt loads, high unemployment and anaemic pace of structural economic reforms needed to boost competitiveness and reduce internal imbalances. With an already dire economic backdrop, deflation will easily set in if the ECB does not act fast. Adding further fuel to the fire, the ECB is worried about a potential LTRO funding cliff given that eurozone banks are due to repay their initial allotments by end-2014 and early 2015, which could precipitate a shortage of liquidity and exacerbate already weak bank lending.

While we expect the ECB to step up to the plate, large-scale discretionary expansion of its balance sheet is still not as straightforward as it has been for the US Federal Reserve and the Bank of England. Traditional interest rates have already been cut to the bone (there is only another 25bps left to cut from the main refinancing rate), the Outright Monetary Transactions (OMTs) facility has been established (implementation can only commence if a member state enters a bailout programme), and additional long-term refinancing operations may have less of an impact this time around given that the 2014 Asset Quality Review (AQR) may deter banks from seeking additional liquidity. As was the case with OMTs and the expansion of the LTRO facility, the ECB could yet devise a new tool that would allow additional policy easing. However, given the aforementioned tools already established, it is difficult to discern what this could be.

The two policy proposals that appear to have the most traction are negative deposit rates and special LTROs (SLTROs). It is possible that the ECB will opt to provide smaller scale LTROs with maturities of under a year to help smooth out the potential bump in liquidity as the combined EUR1trn funding programme from December 2011 and February 2012 matures. Given the already diminishing returns to economic growth from such liquidity injections, smaller scale LTROs would not have much clout, but would be more palatable for the ECB. Although it would be harder to secure agreement on negative deposit rates, this would stand the best chance of coaxing down the euro and providing a significant monetary boost. Such an extreme measure has no precedent (that we know of) in a large economy and if implemented would signal the ECB's intent to do 'whatever it takes'. However, as we have argued elsewhere ( see our online service, November 8, "ECB Cut: Pushing On A String"), levying penalties on deposits would be a risky strategy since the ECB would underminine money market funds and could potentially trigger a seizure in liquidity as bank deposits are withdrawn.

For the time being we stick with our current forecasts which see the euro weakening by end-2014, resulting in a lower US$1.27/EUR average for that year compared to the estimated US$1.32/EUR for 2013. Moreover, we maintain our projection for steady depreciation over the medium term, with a US$1.23/EUR average pencilled in for 2015 on the back of still weak growth and the likelihood of further monetary accommodation.

Risks To Outlook

Which antidote the ECB chooses will have a significant bearing on the trajectory of the euro in 2014. Negative deposit rates would be the most effective in lowering the euro and could see a rapid (and volatile) plunge back towards US$1.20/EUR. However, given the aforementioned risks, we still believe that this policy would be a last ditch attempt to ward off deflation if all other channels have been exhausted. Instead, we would expect support to come from some form of direct liquidity injections to the banking sector.

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