Euro needs the Fed, or QE, for the next leg down

June 9, 2014

EIt has become increasingly clear it takes a lot more than words to sink the euro.

The European Central Bank cut rates as low as they will go on Thursday and announced another round of cheap cash for banks, hoping the euro, which has helped knock down inflation in the fragile euro zone economy, will fall.

Yet the ECB’s efforts yielded little more than a lukewarm response from markets, suggesting that the only thing that will get the euro to fall any further in the very near-term is a change in the outlook for U.S. rates, and through that, a stronger dollar.

A Federal Reserve rate rise isn’t likely for more than a year, despite another solid jobs U.S. report on Friday that took employment back to where it was before the financial crisis set in nearly six years ago.

President Mario Draghi’s latest rhetoric implies the ECB will need to turn a blind eye over the coming months to dangerously low inflation – as well as deflation in several smaller, weak southern European economies – and hope for the best. But euro zone deflation remains a real threat.

No word was spoken about what specific euro exchange rate or range would be required to get euro zone inflation, now dangerously low at 0.5 percent, back to the central bank’s target of close to, but below 2 percent.

And ECB staff inflation forecasts, like those collected from private sector economists polled by Reuters, show no return to the target at any time on the forecast horizon. Both show inflation languishing in the ECB’s “danger zone” of below 1 percent this year.



According to a Reuters poll of leading currency strategists published June 3, the euro, trading well above $1.36 at the end of last week, probably needs to fall substantially to $1.30 or below for the ECB to think it is helping push up inflation – or at least no longer keeping inflation pressures capped.

But only a handful of forecasters, who were already bracing for aggressive action from the ECB, thought $1.30 would be reached any time in the next six months.

The euro fell about a cent briefly on Thursday on news the ECB will offer of hundreds of billions more in cheap cash, only this time with one string attached, requiring banks to lend to non-financial businesses if they take the money. They are under no obligation to take it.

The ECB also extended full allotment at existing liquidity operations until the end of 2016 and said it will abandon offsetting sales of government bonds under its securities markets programme (SMP), which effectively floods the system with another 170 billion euros.

All of that implies that ECB interest rates won’t rise for many years.

Short of launching a full-fledged quantitative easing (QE) programme – like the one the Federal Reserve has nearly wound down and the one the Bank of England slammed its door shut on long ago – it is hard for many to picture what more the ECB could have done.

Lena Komileva at G+Economics said:

 The law of diminishing policy returns at negative rates is already beginning to kick in.

The ECB spent much of its press conference talking about its “big bazooka” of bank liquidity measures, but it could only activate its “peashooter” of negative deposit rates, staying well clear of QE territory.

With Spanish yields at new record lows, the ECB’s negative deposit rate is already driving massive money displacement from money markets into peripheral bonds. This is a confirmation that how the ECB’s measures will ultimately work will depend on the cost of banks’ capital, rather than the scale of additional cheap ECB liquidity pumped into the markets.

But Komileva says there is a silver lining to the fact the euro did not move much.

 On the euro, the market’s anticlimactic reaction is probably a net positive from a medium-term perspective. If the ECB’s negative rate had actually worked to weaken the euro, every other central bank, from Sweden to China, would be rushing to reciprocate with their own negative rates, taking market “bubble” fears to a new level.

To be fair, Draghi already had already managed to talk down the currency from above $1.39 to $1.36 on hints of policy easing at the June press conference, and several off the record comments by officials to the media in the interim. So the immediate worry was whether the measures he introduced triggered a rally in the currency rather than real hopes it might plunge.

But with more than 6 cents to fall before the euro can help contribute to inflation, based on strategists’ forecasts, it remains unclear what would drive the euro lower independently of a rise in the dollar, or QE.

The likelihood of QE happening remains low, especially as purchasing securities held by banks ahead of results due later this year from the Asset Quality Review would defeat the purpose of trying to assess how strong those banks really are.

A recent Reuters poll only had a handful of people saying QE would happen any time soon.

But it is becoming increasingly obvious to some seasoned market professionals that an asset purchase programme is the next step.

Danny Gabay of Fathom Research, a consultancy, said in a note:

The muted reaction to (Thursday’s) announcements from the ECB should have surprised no one. They did nothing to address the immediate threat facing the single currency bloc, which is that of low inflation.

We remain confident that the ECB will embark on a programme of full-blown QE before the end of the year. An end to the sterilisation of bond purchases made under the SMP announced at the press conference yesterday was a small step in that direction. The big leap is still to come.

Even Draghi admitted on Thursday there is more work to be done:

Are we finished? The answer is no. We aren’t finished here.

— with additional reporting from Sumanta Dey

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