ECB getting its way on the EUR, but is pushing against fundamentals
Never bet against the central bank is a common saying in the currency markets and the rout of the EUR recently has certainly proved that point. But longer-term the ECB has its work cut out if it wants a weaker EUR.
With Germany basically onside the ECB looks set for some more unorthodox monetary intervention to kindle the Eurozone's lacklustre recovery and to stave off potential deflation. Part of the game plan is a weaker EUR and so far so good and all achieved just by talking about it.
The forex markets now believe there will be a big announcement from the ECB next month. Although outright quantitative easing doesn't appear to be the cards, at least not yet, other measures such as an interest rate cut or possibly negative interest rates, a new Long-Term Refinancing Operations (LTRO) programme or a combination of these appear to be on the table.
EUR/USD – round one to the ECB
Fundamentals favour a stronger EUR
Sifting through the various pronouncements, particularly from ECB President Mario Draghi, there is a strong desire to direct any stimulus at the real economy and in particular the SME sector. That would suggest possible variations on LTRO or some other type of support for SME lending or the creation of Asset Back Securities (ABS), which pool together Eurozone SME loans.
The challenge is that most lending to SMEs in Europe is done via banks, which might favour a LTRO approach. The corporate bond market is relatively small and mainly serves larger corporate credits. The ABS market needs substantial regulatory support to revive it in Europe. It is therefore a more of a long-term solution, which the ECB is very keen on.
The upshot is that the initial stimulus measures from the ECB may not be that dramatic at first given where it wants it to be directed. For instance, it probably doesn't want to be seen to be supporting peripheral government bond markets – though they may indirectly benefit anyway.
Strong current account surplus
The other factor is that the Eurozone's current account surplus is substantial standing at 2.6% of GDP in February 2014, compared with 1.6% a year earlier. While a weaker EUR is likely to cause some imported inflation, it will also probably stimulate Eurozone exports and in the medium term see the current account surplus rise further putting upward pressure on the EUR.
Though they appear to tolerate a weaker EUR for the time being, other central banks, such as the US Federal Reserve, The Bank of England and the Bank of Japan, may not idly stand by indefinitely while the Eurozone gains a major competitive advantage in global export markets. They basically all favour weaker currencies for their countries.
Further weakness, punctuated by the occasional short-covering rally, probably sums up the outlook for the EUR in the short term. But further out if the ECB really wants a weaker EUR because of persistent deflationary pressures and lacklustre economic growth then it will be forced to be steadily more aggressive and interventionist. And the mood music from the central bank suggests it might be edging towards doing whatever it takes to slay the deflationary monster.
By Justin Pugsley, Markets Analyst MahiFX
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