ECB Tipped to Expand Stimulus, But Unlikely to Prompt Euro Weakness

The European Central Bank is forecast to expand its stimulus programme at its September 2016 policy meeting but there remain signs that the bank is losing its ability to weaken the Euro.

The European Central Bank’s (ECB) policy meeting to be held on Thursday the 8th September will form the highlight of the week for foreign exchange rate traders with apprehension growing that the Bank may introduce new measures that could hurt the Euro.

A survey of 50 leading economists by Bloomberg confirms the September meeting as the most likely at which additional stimulus measures will be announced by the ECB.

80% of economists expect President Mario Draghi and his team to lengthen quantitative easing for a second time.

That would take the asset-purchase programme beyond its current end-date of March 2017 and above the target of 1.7 trillion euros ($1.9 trillion).

A similar share predict the ECB will tweak its purchasing rules to avoid running out of securities to buy.

The Euro has been weakened notably over recent years by past ECB policy that has seen interest rates cut into negative territory and the introduction of a quantitative easing programme.

This has allowed both the Pound and US Dollar to register notable advances since 2010.

There are suggestions that the September interest rate meeting may bring further cut to interest rates and/or an increase in the asset purchase programme.

While this would be expected to weaken the Euro further, of late there has been growing evidence that the ECB is losing its ability to both weaken the Euro and boost inflation.

Recent inflation data have confirmed inflation remains stubbornly low while the Euro looks comfortable above 1.10 against the Dollar and 0.8250 against the Pound.

Despite the prospect of further action, there are suggestions that the ECB has simply emptied its armoury and the Euro’s most likely response will therefore be to strengthen. 

This will provide a major pain-point for the GBP/EUR's recovery and strength may well remain limited as a result.

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Scarcity of Bonds for the ECB to Buy Likely to be a Focus

Analysis from TD Securities suggests that one of the main constraints on the ECB’s ability to further boost prices, and hurt the Euro in the process, is a scarcity of bonds to hoover up in the quantitative easing programme.

Currently 28% of Euroarea bonds and 66% of German bonds are yielding below the deposit rate.

“As a result of this, the ECB have been forced to buy further out the Bund curve to fulfil their monthly buying needs,” says Renuka Fernandez, Senior Rates Strategist at TD Securities.

Eighteen months since the inception of the PSPP, ECB buying along with negative policy rates globally and now political uncertainty as a result of the EU Referendum outcome has pushed a very significant proportion of  European bond yields into negative territory.

52% of Euroarea government bonds are yielding negatively and about 85% of German bonds are yielding negatively.

How much further below negative can the ECB push yields? One suspects, based on the Japanese experience, that the answer is not much further.

Therefore, it will take increasingly creative and more aggressive policy responses to prompt any degree of Euro weakness.

Morgan Stanley: Euro to Remain Strong

There are other reasons to suspect the Euro is likely to be biased higher.

“We maintain our bullish EUR view”, say Morgan Stanley in a recent strategy note, “the EUR and CHF should remain supported as both regions have financial institutions with weak balance sheets and so are unable to export sufficient local-currency-denominated long-term capital to compensate for the current account surpluses.”

The current account surplus means the Eurozone exports more than it imports, and in doing so places upward pressure on the Euro.

Typically, this would be countered by an ability to export capital, i.e. to lend to international customers, which would lower the exchange rate.

As argued, this is not really possible owing to the subdued state of Eurozone banks, ensuring the current account deficit maintains its upward pull on the Euro.

Morgan Stanley also argue that resistance from core Eurozone countries (think Germany) to more aggressive policies that could push inflation rates higher should keep local real rates high, pushing the EUR and CHF higher against most other currencies.

“The EUR does not rise due to a better economic outcome within EMU. Instead it may rise due to the lack of capital exports held back by balance sheet constraints of EMU financial institutions and too high real EUR rates allowing the recycling of EMU’s current account surplus at current FX levels,” say Morgan Stanley.

For now, the EUR may punch well above its economic weight.

"Due to the ‘exhausted’ position of EMU’s yield curve, there is very little the ECB can do to prevent EUR strength," say Morgan Stanley.

The Downside Risks

Of course, there is the possibility that the ECB does succeed in initiating a weaker Euro - what could be the key to such a move?

"ECB President Draghi is expected to remind investors that inflation is low, the economy is weak and easier monetary policy may be needed," says Kathy Lien at BK Asset Management.

Consumer spending has been particularly soft, manufacturing and trade activity took a hit after Brexit and most importantly, inflation remains well below target with year over year core CPI growth slipping to 0.8% from 0.9% in August.

Aside from the decision on rates and Draghi's press conference, the central bank will also release its economic projections and if changes are made, LIen believes they will likely be Euro-negative given the deterioration in manufacturing and inflation data over the past week.

As always, not everyone sees the recent data in the same light.

Aurelija Augulyte at Nordea Markets says the ECB will remain a sideshow this week:

"The meeting this week is unlikely to deliver surprises as the European data, frankly, has been quite resilient.

"With the EURUSD at the ECB forecast cut-off date a tad above their projection (1.13 vs 1.12), and the oil prices somewhat higher (50 vs 43.9), the bias is for upward adjustment in inflation forecast from ECB.

"The market is pricing some 5bp rate cut from ECB within 6 months and 8bp within a year… too much in the scenario where Fed is back hiking rates."

There are clearly a wide range of views on this week's event, typically when there is no clear consensus the ability to be met with a surprise is elevated.

This could well be an intresting week for the shared currency.