A boost for euro

The euro rose over the past days after ECB member Knot became the first to hint that the ECB could lift rates 50-bps rather than 25-bps.

That might happen but, even if it does not, it seems likely that members will talk in more hawkish terms about the policy tightening that is to come. This could provide some modest support to the euro but it seems that there are a number of reasons why such speculation won’t be the euro’s salvation.

If the ECB does ramp up the monetary- tightening rhetoric after new forecasts are revealed at the June meeting, it certainly won’t be the first bank to go down such a path. The FED, for one, has carefully guided rate-hike expectations up, not least when Chair Powell said at the last meeting that rates will likely rise by 50-bps at each of the June and July meetings. This shifting of expectations about future policy rates in the US has come with a rally in the dollar that’s taken it to 20-year highs on the DXY measure against other major currencies.

On this basis, it might be reasonable to assume that the euro will rebound strongly if the ECB ‘catches up’ to the Fed to some extent by pushing up rate hike expectations. But Mr. Steve Barrow, Head of Standard Bank G10 Strategy said he would be wary about this for a couple of reasons.

The first and most obvious one is that whatever the ECB does on rates it is ultimately unlikely to be as aggressive as the Fed. “We have argued before that a fed funds rate in the 4-5% range will likely be needed to break the back of inflation while, in the euro zone, we doubt that a refi rate of above 2% will be necessary”, Mr. Steve Barrow said.

But there is also a second, less obvious reason and it relates to balance sheet reduction. In the US, it looks as if the Fed will be able to engage in reasonably aggressive balance sheet reduction. It already plans USD95bn per month of reductions within the next few months and if it carries on at this pace for a couple of years, it could trim the balance sheet from around USD9tr to perhaps closer to USD6tr; a reduction of a third. It could even be more and/or faster than this if the Fed decides to undertake outright sales of mortgage-backed-securities as it has hinted in the past.

In contrast, Mr. Steve Barrow feels that the ECB will be much more cautious, not least because debt metrics in many euro zone countries are very poor and the prospect of a significant pull back from the ECB might just be sufficient to spark concerns among investors, and possibly even create new debt strains to rival those we saw in the 2010-12 debt crisis – which also hit the euro hard. You can see that euro zone officials are concerned about what could happen as policy rates rise and net asset purchases end.

Rumours are swirling that the ECB is working on a new emergency tool to deal with debt strains having realised that the Outright Monetary Transactions (OMT) plan that was announced by former ECB President Draghi in August 2012 is unlikely to be fit for purpose. It is possible that the ECB could concoct some sort of instrument that allows it to reduce its balance sheet as fast – if not faster than the Fed – but we doubt it. Instead, the ECB will go very cautiously, not least because of the possibility of recessions in some countries that have both hefty reliance on Russian energy and a very large debt-to-GDP ratio, like Italy. Such economic downturns could ramp up the pressure on bond spreads that have already started to materialise. If the ECB is engaged in a rapid balance sheet reduction programme at the same time it might be forced into an embarrassing policy reversal, which could be particularly detrimental to the euro.

“While we don’t doubt that policy rate changes are the public face of monetary adjustment, and could lend the euro some support in the short term, the overall thrust of monetary policy changes from here will likely be supportive for the dollar, and especially so if ECB balance sheet reduction creates any semblance of a new debt crisis”, Mr. Steve Barrow stated.