FX: the EUR trap

Being positive on EUR because of the weak underlying macro has been my key thesis for being bullish EUR over the past two years. Deleveraging / shrinking economy has helped the EUR a lot. Are we there yet? Or, if Europe is next Japan, is EUR the next JPY then?

Figure 1. Worst case is…

The ECB has just announced new measures to encourage European banks to lend – that is, at least decelerate deleveraging. The markets, judging from recent divergences between ECB balance sheet and EUR rates and cross currency basis and EUR itself, seem to have price in most of the expansion in the ECB’s balance sheet. Now that ECB has communicated all it could for now, only the actual changes of action will matter. The relative Fed/ECB balance sheet has trended with EURUSD over the past few years. But it’s tricky now.

• If ECB’s balance sheet does not expand, or only little, because banks keep deleveraging – then we are back to Figure 1. Hello, Japan!
• Alternatively, if ECB’s balance sheet does expand because banks draw on ECB’s liquidity to lend to European companies, this will be: a) Bad for the euro: deleveraging finished; but b) Good for the euro: European economy is recovering!

Dwell for a second on the point b). If it banks start lending again in Europe, higher inflation will show up, and if it does, rest assured, ECB, hike earlier than Fed would ever do: they have just one single mandate instead of Fed’s two, and have not, unlike Fed, hinted willing to let inflation overshoot for some time. Thus any euro area inflation pickup would cause some drastic reprising of EUR rates, in light of the fact that nobody sees any rise in European rates for as long as the economist’s eye can see…

Figure 2. Low for ever…ever?

Would ECB venture more than what it has announced so far? That is, do unconditional QE like Fed, meaning not targeted and thus implications for growth more unclear. Not any time soon. Most recent hints from ECB, e.g. Hansson’s last week, suggest that even ABS-QE is still elusive; and will be tested only after the TLTRO is tried out; and only after the effects of that will be seen. Which will take, like… months, if not more than a year. And if ECB does eventually do outright QE because of renewed disinflation, guess what Fed will be doing at that time? Mind you, Fed’s Yellen last week hinted the quantitative easing may come back as a tool.

The key thing is… ECB is still the most cautious central bank out there. ECB is Bundesbank in disguise, even considering all the measures announced so far. And we know how Bundesbank has meant for the European currency over the past few decades. Because, again…it’s the real rates that matter!

Figure 3.  Price wedge…

Figure 4. …Thus no surprise

To conclude: it’s difficult to see EURUSD lower; slower deleveraging is both bad and good for EUR, and ECB is done all it could for now. Last week the EURUSD has tested the important 1.3490/1.3500 support area – keep it long (1.40+ target still alive), as long as closes above 1.3490. If fails, 1.3360/80 is likely. But that is as low as we could see the EURUSD trade in the coming months. IMHO.

Figure 5. Trend is your friend