ECB Lays the Ground for Asset Purchase Extension Beyond September 2016

The euro exchange rate complex could come under significant pressure if the ECB gives a hint that it is to push its quantitative easing programme beyond September 2016.

Above: ECB's Praet may be laying the foundation for further euro-negative policy decisions at the ECB.

The outlook for the euro improved notably in August as demand for the shared currency was boosted as global investors sold their exposure to emerging market currencies.

ABN Amro and Intesa Sanpaolo were just two major institutions who announced they were looking to upgrade their forecasts while others saw the recent rally in the EUR as improving the technical picture for the shared currency.

Rest assured though, the ECB will not be happy with news that the EUR is rising as they are desperate for lower interest rate yields and a lower exchange rate to assist the recovery of the Eurozone’s economy.

The ECB’s asset purchase programme, loosely referred to as Quantitative Easing, has been introduced to stimulate the Eurozone economy by making more capital available to companies, keep interest rates low and force the value of the euro lower.

It has worked - we have seen the euro fall significantly since 2014 allowing the pound to euro exchange rate to breach the 1.44 level and the euro dollar touch the 1.05's.

However, ECB Chief Economist, Peter Praet, delivered forceful remarks mid-week that downside risks to inflation had increased. What he means is that downside risks to the economy have increased.

This will lead to expectations of ECB staff CPI forecasts being cut next Thursday and raises the prospect of front-loaded QE.

‘Front-loaded QE’ simply means the ECB will speed up their quantitative easing programme which will bring a faster rate of depreciation in the euro.

“Any fresh hint of front-loaded QE today could push EUR/USD below key short term support at 1.1320 (200 day m.a.) and add to the tentative view that Monday’s 1.1714 high was the extent of the correction. A close today above 1.1400/1440 suggests the correction may still have further to run,” say ING.

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Could the ECB Extend QE?

So far the ECB has decided its present QE programme will more than €1tn in assets purchased, including government and private sector bonds, by September next year.

What would certainly be a shock to the euro will be if this programme is increased and extended beyond September.

“The ECB may be forced to announce an extension of QE before year-end – possibly by extending the asset purchase programme beyond September 2016 – if downward inflation pressures were to continue or financial conditions were to tighten materially,” says Antonio Garcia Pascual at Barclays.

Barclays expect President Draghi to send a strong message in the September meeting that could open the door for further policy action later in the year, conditional on the evolution of external factors and the inflation outlook.

Stoking the fire is Bank of America Merrill Lynch who have told clients today that avoiding more euro re-appreciation is the short run priority – weak euro is QE’s most tangible result.

“Talking dovish”, i.e. unambiguously recognizing the risks to their outlook and underlining the possibility to do more, should be the ECB’s first port of call for next week suggests Gilles Moec, Europe Economist at BofA Merrill Lynch.

Furthermore, "The ensuing revision in the ECB’s inflation trajectory – with Praet already acknowledging downside risks there - will force the Governing Council hand on beefing up QE by year end, in line of our long held view that the inflation outlook would force the ECB into more for longer.

"In our view, announcing that QE will continue beyond September 2016 would be a powerful form of forward guidance, allowing to maintain a suitable "policy gap" with the Fed."

September therefore promises to hold more risk for the euro exchange rate complex than we initially thought.

Be prepared for potential downside.

Commerzbank: An Extension is Coming, Just not Yet

ECB Vice President Constancio recently dampened speculation that the oil price slide and the crisis in China had given rise to a fundamental change in the outlook.

He affirmed that it was too early for the ECB to respond to developments in China and that the lower oil price was an external shock which the ECB could not and should not correct.

"Although we have long forecast that the ECB will extend QE beyond September 2016 or even increase the QE volume before then, we expect no big steps next Thursday, because, according to Praet, the Council will decide on the basis of the new projections – and here we expect only a small downward correction," says Commerzbank's Dr. Michael Schubert. 

Commerzbank say the ECB Council will probably decide to continue with its steady-hand policy, although risks with regard to China have grown and it turns out that the bond purchases have had little effect so far.

One important reason for a wait-and-see stance is that the ECB staff will probably make only minor downward corrections to their projections.

A Better Week Ahead for Pound Sterling?

Markets have pushed back expectations for the first BoE hike to August 2016 following “Super Thursday”, as well as the market turmoil of the past couple of weeks and dovish comments from Fed policy makers. We think this is too far out.

“We see a BoE move by 25bp in February. Markets will likely adjust their assessment as they digest the massive moves seen this August. We expect confidence to return to markets soon on the back of positive fundamentals,” says a foreign exchange note from UniCredit Bank.

For the UK, the upcoming PMI data could be a starting point.

Manufacturing will likely slow down to 51.5 as the sector continues to struggle from sterling’s appreciation.

“But on the back of strong consumer confidence and a pick-up in wage growth we continue to see the services sector as robust at 57.5. Short-term, there is a risk that this may not be enough for cable to revert back to its upward trend, but we expect this to correct over a medium-term horizon,” say UniCredit.