The Euro Could Rally if the ECB Announces a FLS-like LTRO
Fundamental Forecast for Euro: Bullish
- The Euro remained in favor as weak data has already been priced in (see last week’s forecast).
- Weakness in the commodity currencies has seen a continued pivot to Europe.
- Slight rebound in November CPI diminishes chance of outright dovish ECB action in December.
The Euro was a top performer the last week of November, capping off a strong final three weeks of the month. After a batch of weak inflation data prompted the European Central Bank to cut its main refinancing rate to an all-time low of 0.25% on November 7, the Euro has been in full-on recovery mode (the EURUSD produced its monthly low that day at $1.3296; it closed the month at 1.3591).
It wasn’t just against the US Dollar the Euro performed well, this past week (+0.24%) or since the November 7 close (+1.65%). The Euro added +1.38% against the Japanese Yen this week and +4.90% in November; and +1.06% against the Australian Dollar this week and +4.56% in November.
The rebound seen by the Euro has been, in part, due to stability in incoming price and growth data. The November CPI estimate came in at +0.9% versus +0.8% expected, a rebound from +0.7% in October (y/y). Euro-Zone Economic Confidence climbed to 98.5 in November, the highest reading since August 2011 (99.0). On the other hand, the German labor market unexpectedly lost 10K jobs in November. The short-term fundamental momentum for the region is slightly improved, despite some weakness in the core.
We thus maintain that, in light of the Euro’s performance in recent weeks, absent a further deterioration in data, negativity regarding the European continent has been priced in. It should be considered a positive sign for the Euro that non-Euro using countries are seeing their currencies appreciate as alongside; it speaks well to market participant’s outlook on the entire region’s growth.
The ECB’s December policy meeting this Thursday will help clarify the prevailing view on growth in the region. Many market observers have correctly pointed to the dramatic contraction in the ECB’s balance sheet over the past year as a reason for sluggish growth. The ECB’s balance sheet has declined by -24.4% in the 52-weeks ending November 22, 2013; to contrast, the Federal Reserve’s balance sheet has grown by +36.9% over this same period.
Similarly, excess liquidity in the Euro-Zone – the amount of surplus funds in the region’s financial system – has fallen to €159B, below the ECB’s implied €200B threshold for additional accommodative policy. At the last ECB policy meeting, President Mario Draghi noted that while another LTRO would relieve any liquidity concerns, in absent of a crisis (sovereign yields are significantly lower than they were this time last year), there’s little reason to just hand capital to the banks.
On October 3, I suggested that“If loan growth remains weak, but another crisis does not come into play, then the ECB might experiment with a BoE-style Funding for Lending scheme, targeted at small- and medium-sized enterprises.” Heading into the ECB meeting, reports from Germany (via Reuters) suggest that the ECB is “considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses.”
Ultimately, if the ECB announces a FLS-like LTRO, it could prove supportive for the Euro. A headline suggesting that a liquidity injection hitting the region could initially weigh on the currency – just as LTRO1 and LTRO2 did in December 2011 and February 2012, respectively. However, these measures could support faster employment growth, a rebound in the housing market, and a healthier service sector over the coming year – just as the Bank of England’s FLS did from July 2012 to November 2013. In that case, Euro weakness might be short-lived – any further dovish policy action might be priced out for at least the 1Q’14. –CV
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