ECB's Hold Offers Euro Rally Room as EONIA Rates Steady
Fundamental Forecast for Euro: Bullish
- Lack of easing by ECB sparks Euro reversal versus Australian Dollar and Japanese Yen.
- Have a bearish (or bullish) bias on the Euro, but don’t know which pair to use? Use a Euro currency basket.
The Euro stayed buoyant this past week after a rough start to 2014, as the European Central Bank warded off calls for more accommodative policy action. Policymakers from across the Euro-Zone are concerned that if growth does not pick up soon, a Japanese-like era of deflation could set in as both businesses’ and consumers’ expectations for price pressures are diminished in perpetuity.
For a highly anticipated meeting, the February gathering of European monetary policymakers was, well, boring. ECB President Mario Draghi played the same tune at his press conference: credit growth and inflation both remained low; unemployment rates remain too high especially in the periphery; and that growth should resume shortly.
The ECB’s decision not to act and toe the line after the softest CPI reading in the post-2008 crisis era (+0.7% y/y in January) surprised some as speculation was building that a non-standard rate cut to 0.10% from 0.25% would be possible (contemporary central banks usually adjust rates in 25-bps increments). On top of that, several forecasts saw new policy measures being unveiled to make policy even more accommodative than it is currently.
But before Friday, the ECB was unaware of the legality of its OMT program, the Euro-Zone’s financial safety net. This was the first “whatever it takes” measure that the ECB staked out in order to help calm tensions in bond markets in July 2012. An unlimited program in nature, there was questioning that, in theory, if the OMT was ever activated, could it bring price instability to the region? Fears are not unfounded: if the ECB were to stop sterilizing its bond purchases (offsetting by draining equivalent amounts of excess liquidity), excess liquidity in the Euro-Zone would more than double (excess liquidity was €143B for the week ended February 5; bond sterilization is approximately €175B).
The fear for Germany is that the release of this extra capital would cause inflation to jump; and any policy that cuts against Article 88 of the German Basic Law is deemed unacceptable. The German Constitutional Court basically squashed any hopes of unsterilized bond buying in Europe; or in other words, there won’t be a European QE. A central tenet of our thesis for Euro strength over the past several months and for 2014 is that the ECB would refrain from providing further liquidity to the banking system carte blanche, meaning a massive balance sheet expansion would be unlikely. If European QE is no longer on the table, then traders have one less reason to hold a negative view on the Euro.
Certainly, A look at EONIA rates (interbank lending rates) shows that the cost of capital is falling and the AQR (Asset Quality Review, the stress test implemented by the ECB once it took over supervisory role of the Euro-Zone banking system at the start of the year) may be impacting sentiment. The recent high in EONIA came on December 31, 2013 (0.446%), the cutoff date for Euro-Zone banks to submit their financial metrics to the ECB. Ever since the cutoff date, EONIA rates have trended lower: settlement at Friday came in at 0.131%, and the 20-day average was 0.205%. Upside pressure in EONIA at the turn of the year may have been tied to a combination of LTRO repayments as well as banks attempting to hoard capital ahead of the stress tests.
In a week that’s rather thin on the calendar – 4Q’13 GDP readings are due from Germany and the broader Euro-Zone – we find that the ECB’s “wait and see” approach will continue to be the course of action going forward. If the ECB’s options are limited after the German Constitutional Court’s ruling (which now heads to the European Court of Justice), a BoE-styled Funding for Lending Scheme (FLS) has become a more appealing outcome (and it could address credit concerns without putting the Euro at risk of a massive ECB balance sheet expansion that another LTRO or a Fed-styled QE would bring). These developments warrant a more bullish outlook for the Euro over the coming days. –CV
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