Will the ECB opt for QE-plus?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

When the gov­ern­ing coun­cil of the Euro­pean Cen­tral Bank con­venes this Thurs­day in the Mal­tese cap­i­tal Valetta, the as­sem­bled pol­i­cy­mak­ers will be forced to con­tem­plate a track record of quan­ti­ta­tive eas­ing that at best can be de­scribed as “mixed”.

True, since the ECB an­nounced its EUR 60 bln a month pro­gramme of as­set pur­chases in March this year, eu­ro­zone ac­tiv­ity has staged a mod­est come­back, with growth ex­pected to rise to 1.6% in the third quar­ter, com­pared with 1.2% in 1Q. Yet the de­clared aim of QE was not to stim­u­late growth, but to avert de­fla­tion, and on that front the ECB has been rather less suc­cess­ful, prompt­ing spec­u­la­tion that the gov­ern­ing coun­cil could de­ploy even big­ger weaponry at its Valetta meet­ing in a re­newed at­tempt to hit its in­fla­tion tar­get.

Since it be­gan its as­set pur­chases, the cen­tral bank has watched the euro gain 8% against the US dol­lar, and roughly 5% against a trade-weighted bas­ket of cur­ren­cies. Al­though the ECB in­sists it does not tar­get the ex­change rate, cur­rency ap­pre­ci­a­tion has ex­erted de­fla­tion­ary pres­sure on the eu­ro­zone, help­ing to tip head­line in­fla­tion back be­low zero to -0.1% in Septem­ber, and drag­ging core in­fla­tion down to 0.9%, well be­low the ECB’s tar­get rate for head­line in­fla­tion of “be­low but close to 2%”.

Af­ter the euro last week tested $1.15, par­tic­i­pants ex­pect the mar­ket to push the sin­gle cur­rency still higher un­less the ECB acts this week to cap the ex­change rate. Whether the cen­tral bank would find it sim­ple to limit the euro’s gains is ques­tion­able, how­ever. Typ­i­cally, the euro-US dol­lar ex­change rate tends to move in line with in­ter­est rate dif­fer­en­tials, with the two-year in­ter­est rate swap rates a use­ful guide to past fluc­tu­a­tions. If the euro’s strength over the last six months had been the re­sult of steep­en­ing at the short end of the euro yield curve, the ECB would find it rel­a­tively straight­for­ward to flat­ten the curve again and weaken the euro. But as the chart shows, the main driver of the euro’s re­cent ap­pre­ci­a­tion has been the down­grad­ing of US in­ter­est rate ex­pec­ta­tions. Al­though the euro’s two year swap rate has sunk to just 0.03%, over the last two months the equiv­a­lent US dol­lar rate has fallen more steeply, as dmi in ish ing ex­pec­ta­tions of an early Fed­eral Re­serve rate hike have led to a repric­ing of the US yield curve. As a re­sult, the spread be­tween US and Euro­pean two year swap rates has nar­rowed to 69bp from just short of 100bp in Au­gust. If dis­ap­point­ing data fur­ther erodes US rate hike ex­pec­ta­tions, it is likely the ECB would find it­self forced to take dras­tic ac­tion to pre­vent the euro from ap­pre­ci­at­ing above $1.15. What could it do?

- In­crease the monthly vol­ume of its as­set pur­chases to force short rates lower, which would drag longer ma­tu­ri­ties back to­wards their April lows. How­ever, this might not be enough to counter an­other Fed de­lay.

- Sig­nal an ex­ten­sion of QE be­yond next Septem­ber, flat­ten­ing the yield curve by low­er­ing the two to five-year tenors.

- Re­duce its de­posit rate be­low -0.20%. Al­though ECB pres­i­dent Mario Draghi has said that -0.20% marks the lower bound, the Swiss cen­tral bank has cut its de­posit rate -0.75%, flat­ten­ing the swap curve so much that the two-year rate is now -0.7% and the five-year -0.42%.

How­ever, while any, or all, of th­ese mea­sures could suc­ceed in cap­ping the euro for now, the ex­tent to which the longer term ef­fec­tive­ness of Europe’s QE pro­gramme de­pends on evolv­ing Fed pol­icy is likely to per­suade the ECB to hold its fire at Thurs­day’s meet­ing in the hope that the next month or two will de­liver greater clar­ity on the im­pact of China’s slow­down on the eu­ro­zone and US economies, and on how in­fla­tion will move once last year’s drop in oil prices falls out of the cal­cu­la­tion.

If the ECB does de­cide to wait be­fore wheel­ing out even big­ger guns, the euro’s risk will re­main to the up­side, de­spite the damp­en­ing in­flu­ence of Draghi’s dovish talk.

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