Will the ECB opt for QE-plus?
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.