Monetary easing is, everything else equal, currency negative, but we see important offsetting factors when it comes to the euro at the moment. Below we present the five key reasons why we see the ECB LTROs as euro positive, but also why we believe that the positive factors are much more exhausted at the second 3Y LTRO compared to the first.
QE can also have currency positive effects
Five reasons why the LTROs have lifted EUR/USD and are likely to remain supportive:
- Positioning: Investors were long the dollar prior to the Fed’s QE, but short the euro before the first 3Y LTRO. And investors remain near record short the euro before the second LTRO according to the IMM data.
- Credit spreads: The potential for currency positive effects via tighter credit spreads are much bigger in Europe than it was in the US. The ECB has succeeded in bringing down sovereign bond spreads from elevated levels and has thus significantly reduced near-term funding risks.
- Balance of payments: QE increases downside currency risks more for an economy backed by a large current account deficit (like the US) than for an economy backed by a surplus (like Switzerland). The eurozone only runs a modest C/A deficit.
- Inflation expectations: The currency negative effects of monetary easing primarily run through higher inflation expectations and the resulting decline in real interest rates. Inflation expectations have only risen moderately in Europe (5Y German breakeven inflation is up little more than 50bp from the November low) and we doubt that inflation expectations will truly spike with unemployment at elevated levels and most of the eurozone caught in recession.
- Risk correlations: The euro is positively correlated with risk assets – at least against the dollar. In other words, EUR/USD tends to rise when risk performs.
The announcement of a high allotment today in the second 3Y LTRO would thus be expected to push EUR/USD higher. This also appears to be the consensus interpretation in the market and risks are that market expectations have become stretched. EUR300-500bn is widely cited as the likely outcome range, but looking at recent market performance it appears that at least the FX market is pricing an expected outcome to the high end of this range. This raises the risk of a temporary setback in EUR/USD on a medium to low number.
For the medium term, we remain positive on EUR/USD. Global macro data has stabilised and investors would usually be neutral or net short the dollar at this stage in the business cycle. This is not yet the case, however, and a key reason why we have long argued that EUR/USD would end the year higher (current 12M forecast: 1.36).