EURUSD impact from ECB action

I thought I should set out the EURUSD impact I see from different alternatives the ECB could set out, should a high Euro take inflation lower than their projected level. Short term – it is not about inflation getting to the targeted level of 2%. That might take us a couple of years into the future. Focus now is on inflation towards the targeted level, which at the end of the year, we assume to be 1.4%. 

To speculate on whether or not the ECB will do something is not the purpose of this paper but having said that it is tempting to just dwell a few seconds on why they have not done more than they have. 

Inflation is so low and possibly still falling, that one could have argued that central bankers’ normally would have acted upon the data they know. And I think they would have – if it was not for one factor they have not talked about – and likely should not.

The results of Euro area banks’ stress tests will be out in a few weeks. I think that could be bad readings – both in the number of banks failing the test criteria – but more importantly – the capital required to get banks above the Basel III minimum criteria for Tier I capital. 

Figures have been rumoured and some estimates show a need for 700 billion euros of Tier 1 capital. This is an enormous amount – more than what the Fed pumped into the US banking system in the days after the collapse of Lehmann Brothers. 

The impact of such results could both be a lower Euro and possibly also financial turmoil. My feeling is that the ECB wants to be prepared for this and preserve all their ammunition for preserving stability and liquidity through all measures being available to them. 

My further thinking is that inflation concern likely will be 2nd in their mind when these results are out. The lower Euro you could get from these results will likely have a positive impact on inflation anyhow. 

I simply think their thinking is that to do something now – for reasons of inflation – is possibly to waste a few of those tools they think they might need in not that long time. 

The reason they don’t mention this should be obvious. Should central bankers be seen to be casting worries and preserve tools for something coming later, financial turmoil will erupt before knowing the test results. 

It is a rather speculative line of arguments and the thoughts are triggered from what I see as not classical behaviour of central banks – the refusal not to be more proactive in terms of the existing inflation scenario. Go through the history and you will see that central bankers have been pretty active in this respect. But this time around – no – and what is mentioned above might be a reason for this.

Back to what I was to write about:
Say the Euro stay high or even higher over the coming weeks. From that we should assume that inflation will stay below the ECB’s own projections. Here are some of the options the ECB has got – for which one or more might be set in motion.

A. Lowering lending rates (including the MRO rate)

• This would likely be by 0.125% p.a. leaving the MRO at 0.125% p.a. I would think the EURUSD impact would be rather minor – possibly not more than a dip of 50-100 pips as an initial reaction and then likely nothing more afterwards.
• I see it as rather unlikely that lower lending rates would be the only measure undertaken and that this measure is likely done in combination with either of the ones listed below. The reason for this is simply that doing this on its own doesn’t have the intended effect on Euro and likely not on lending activities either. 

B. Purchases of bonds in the bond market

• This would be a more “classic” easing program – a bit in line with the QE programs the FOMC has conducted throughout 2010-2014. 
• The short term impact for EURUSD might be substantial – say in the area of drop of 250-350 pips – partly from the psychological effect on markets of seeing the ECB starting printing money.
• The long term effect is a pure consequence of volume and length of time. They might set out a “pot” – fixed volume – to be used for this - or – they might say it has an open ended structure – meaning it could go on for a long time.
• In terms of assuming the long term impact, I think one has to reflect on why they would choose to do this. It would have a rather minor impact on short term rates but likely a rather substantial impact on longer term bond yields. A bit depending on what paper they buy – they likely will do a mix – one would expect the yields of all peripheries to get lower – as well as those from more prime issuers in the Euro area. 
• The consequence of this might be that those in the bailout fund might be able to borrow in the market at much lower rates than previously seen and that the bailout fund in fact can come to an end. It will not be abolished but it could become empty. Should that be the case, then it is a bit like turning the clock 5 years back and “forgetting” Euro area debt problems. It could be a Euro supportive effect to see the bailout fund empty. 
• That the ECB starts buying bonds might trigger investors to do the same and if they are from outside the Euro area, this could mean Euro purchases. Again - something that would reduce the negative Euro impact.
• Still – printing of Euros is diluting the value of the currency and one should assume that the overall impact from this – long term – is one of a weakening Euro. 
• I would say that should this program be anything near 50% of what QE3 was in the US, the long term effect on the Euro should be one of taking the currency below 1.3000 and possibly as low as 1.2750. This is of course depending on a lot of other factors – the economy being one major point – which is not discussed in this paper.

C. Purchases of bonds from banks only

• This is an option for which the point would be to assist banks in need of trimming their balance sheet as well as offering incentives to banks to increase their lending to private sectors in general.
• It would likely have the same impact on interest rates as set out under B) but as it likely would be a smaller program than B) there might be less of Euro printing and hence less of long term Euro weaknesses. 
• I would think the short term effect would be one similar to B) – say with a EURUSD drop of 250-350 pips – a bit also from that the market would not really see the big difference between B) and C).
• The long term effect could be very different – partly from C) being a smaller program than B) and partly from that lending from banks to corporates could pick up form this and thereby give better growth prospect for the economy. It could also be very beneficial for banks in need of trimming their balance sheet. As such the fall for EURUSD long term might be smaller and at some stage possibly shift to a upturn. I would think that the drop for EURUSD long term from C) would be limited to 1.3250-1.3000.

D. Conditional purchases of asset from banks

• This is an alternative to C) – directed towards banks only – and one for which a wider range of banks’ balance sheet items could be included. It likely would be in the form of structured packages of loans to corporate and private sectors, bought by the ECB on rather strict low risk credit criteria.
• The idea behind this product is to offer cash to the banking sector through purchases of banks assets but on condition that the cash the ECB provides is used for the purpose of new lending. 
• In addition to be easing in general, this product would enhance banks’ lending activities, which likely is an additional point on the ECB’s agenda. 
• Short term the EURUSD might go a bit lower from this because of the easing element it represents. I would say such a move could be anything like 100-250 pips.
• Medium to long term it is an open question how this would impact EURUSD. The element of Euro printing you would see from this is Euro negative. But the increased bank lending to corporates could represent a boost to the economy. As such – long term this could be EURUSD supportive.

E. Negative deposit rates

• This is likely the most controversial measure the ECB could implement and likely the one that would have the greatest negative impact on the Euro.
• At moment the ECB offer 0% for banks depositing their surplus liquidity with the ECB. Total deposits have been in the area of 30 billion Euros lately.
• Should the ECB offer negative interest rates for these funds, there is all reasons to believe that there will be less of such deposits and that the negative deposit rate offered by the ECB also would be transmitted to negative deposit rates offered by banks to their clients. The natural consequence of this is that less investors will hold Euros and opt for other currencies instead. You get sales of Euros and a lower Euro value.
• There is a supplementary consequence you can get from this, which is that Euro area banks will lose deposits. Should clients opt for deposits in other currencies, they might also opt for banks outside the Euro area. This is a risk element which could cause strain to Euro area banks’ liquidity and one for which I am sure the ECB would not be too happy with. I think this risk to liquidity is the main reason we have not seen negative deposit rates so far.
• We have no reference for the use of negative deposit rates in the Euro area. It has been used by Swiss banks when the CHF was too strong and also by the Danish National Bank on one occasion. 
• Short term I think this would affect EURUSD by minus 250-500 pips. Should deposit rates remain negative for some time, you will get further falls for the Euro. Medium term this tool is the one that could take EURUSD down to 1.3000-1.2750 and long term even lower as it would be seen as rather questionable why they would do it for so long.

Summarised the likely EURUSD impact from ECB taking action on lower than projected Euro area inflation could look like the following: