Doing nothing is an acceptable strategy for trading the markets at certain times.
However, the European Central Bank’s (ECB) decision last week neither to cut its main refinancing interest rate from a record low of 0.25%, change the marginal lending rate of 0.75%, or to push the zero deposit rate into negative territory surprised many market players – and kept the euro’s recent bullish trajectory intact.
“Many people think that the decision to keep interest rates on hold – and the accompanying statement by [ECB president Mario] Draghi – was the central-bank equivalent of a trader talking his book, as anything else might well have caused a deflationary loop in the eurozone,” says Jane Foley, senior FX strategist for Rabobank, in London.
“And, in any event, it could just about be justified on the economic projections that ECB staffers produced.”
Indeed, at the presentation made shortly after Thursday’s “no change” decision by the ECB, Draghi was keen to highlight that, according to ECB projections at least, the prospects for deflation in the region remain remote. The ECB forecasts inflation at 1% for 2014, 1.3% for 2015 and 1.5% for 2016 and GDP growth to increase 1.2% for 2014, 1.5% for 2015 and 1.8% for 2016.
Draghi also said the weak loan dynamics in the currency bloc could well just be a reflection of the lagged relationship with the business cycle.
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Foley says these assumptions do not look unfounded. Core inflation was 1% in February, the highest level since September, while GDP in the bloc grew by 0.3% in the fourth quarter of last year. Economic sentiment rose to its highest level in more than two-and-a-half years in February, when services and manufacturing expanded the most since June 2011.
However, the ECB remains cognisant of the dangers of a continued strength in the euro.
“It would be wrong to represent the [ECB governing] council as being comfortable and complacent with the outlook described by these projections, as the introductory statement refers to the gradual economic recovery, the gradual upward movement in inflation and the high level of unemployment,” says Richard Barwell, senior Europe economist for RBS, in London. “So the risks to the economic outlook remain to the downside.”
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Barwell notes that when Draghi was prompted to comment on the euro-area as a new monetary colossus and a beacon of hope for the huddled masses yearning to be stable, he was careful to offer a glass-half-empty rejoinder, saying that: “The euro is an island of stability, but it will have to go back to being also an island of prosperity and job creation.”
Moreover, Draghi highlighted the ECB’s rule of thumb that for every 10% appreciation in the effective exchange rate of the euro, 40 basis points to 50bp was shaved of the rate of inflation.
Given Draghi’s principal overall strategy appears to be to let the recovery erode idle productive capacity and boost prices, it was not surprising that there was neither an announcement of any bond-buying programme, as many analysts have been predicting, nor even of releasing liquidity linked to the sterilization of crisis-period bond purchases as part of the Securities Markets Programme.
In the case of the former, says Foley, the mere announcement of such an “extraordinary” measure would probably have caused more problems than it fixed, with markets interpreting it as a sign of anticipated weakness in the eurozone’s credit sector.
The same argument applies to the latter, she adds, with the further negative nuance that the Bundesbank has been against any such moves to boost liquidity for a long time. Even the notion of the sterilized operation provoked the resignations of Jürgen Stark and Axel Weber, ECB chief economist and Bundesbank president, respectively, in 2011.
More recently, the Bundesbank testified before the German constitutional court that even the more rule-based outright monetary transactions sovereign bond purchases that Draghi has floated are in violation of the ECB’s charter.
Nonetheless, says Barwell, there is still a risk-based argument for looser policy, even if there is reasonably strong conviction around the profile of domestically generated and headline inflation, as well as the resilience of inflation expectations.
“First, inflation expectations could slip their anchor in response to a sustained inflation undershoot without any further downside risks crystallizing,” he says.
“And, second, there is a purely practical consideration that with inflation already low and the recovery still in a fragile position, the situation could become extremely challenging if the euro-area were hit by another significant downside shock.”
On that basis, he concludes, there is a prudential case for providing more stimulus than appears necessary on the central case forecast so the system is better able to withstand shocks.
However, with the US dollar not having firmly embarked on the uptrend that many were predicting it would appear the ECB’s flexibility on softening the euro’s enduring strong performance is limited.
Adam Myers, European head of FX strategy for Crédit Agricole CIB, in London, says that EUR/USD does not fall because central-bank reserve recycling flows are confounding traditional growth and policy drivers.
“As the [US] Fed printed an unprecedented amount of USD, many FX reserve manager roles have shifted towards a more active role where investment and diversification become pivotal – and for a select few reserve managers tied via their passive receipts to the USD, and thus Fed policy, this new strategy has led to ongoing USD-recycling, or rebalancing, into a broader portfolio of currencies,” he says.
“So strong has been this USD-recycling effect, it may have come to dominate FX markets in recent years, helping to explain recent EUR/USD resilience.”
In this context, says Myers, although the IMF publishes its central bank FX reserve manager allocations (the Cofer) each quarter, these are reported on a voluntary basis, with three of the world’s largest FX reserve managers – China, Russia and Saudi Arabia – choosing not to participate.
As a result, the IMF reports on only 54.1% of total reserves, leaving a gaping hole.
To address this, Crédit Agricole has taken the weights from IMF-reporting managers – the largest being Norway, Japan, euro-area, Switzerland and Singapore – and overlaid these on the unallocated reserve component.
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Using this approach an extra $1.25 trillion in EUR reserve holdings is exposed, bringing total central bank EUR reserve holdings to $2.75 trillion – close to double the IMF-reported $1.5 trillion figure.
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Beyond this simple approach, and assuming an additional 20% of passively received USD receipts – such as those from Norway’s energy sector – are diversified into EUR each quarter, Myers estimates “hidden” EUR reserve holdings rise to $1.7 trillion.
This takes the total amount of EUR held by central bank reserve managers to $3.12 trillion, providing a substantial source of artificial support for the currency as this process continues.
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