The euro exchange rate complex will not suffer the falls many are expecting should the ECB extend its asset purchase programme (quantitative easing).
Speculation conerning an extension to the ECB’s programme of quantitative easing has increased in the wake of the publication of the latest set of Eurozone inflation numbers.
From a central banker's perspective it can be argued that the pumping of 60BN euro per month into the Eurozone economy does not appear to be pushing up inflation i.e. the positive impact on economic activity appears to be weak.
What action can the ECB do to boost inflation? Pump more money into the economy of course!
This is widely held to be a negative scenario for the euro exchange rate complex which could suffer significant falls, as it did when the programme of QE was first announced and implemented.
The euro to dollar exchange rate fell significantly in the run-up to the announcement of, and in the wake of, quantitative easing. However, declines from above 1.32 have now halted and the EURUSD is caught in a sideways movement between 1.14 and 1.10.
There are many analysts still holding out for a fall to parity and below in the euro to dollar exchange rate and the catalyst for the decline is believed to be an extension to the present programme.
More Quantitative Easing to Have Limited Impact on the Euro
We have already heard from Barclays that the impact of any fresh stimulus by the ECB could be limited. The bank says what is needed to really get the exchange rate lower is a further cut to the base interest rates.
ING appear to agree with this viewpoint - the Dutch bank expects a limited negative impact on EUR from more ECB QE, certainly the impact will be much lower than that seen in January 2015.
Economists argue the ECB has three options to expand the asset purchase programme:
(1) Lengthening the programme beyond September 2016;
(2) Frontloading the current QE programme (ie, more now, less later); and
(3) Increasing the monthly volumes of asset purchases (either over the entire duration of the programme or over a part of the programme).
Frontloading QE would also have a limited impact as it would not be considered as an extension of QE, and thus would have a minimal impact while option number (1) would be ineffective considering we are still a year away from the end of the programme.
The ECB will want results now.
ING Chief Eurozone Economist Peter Vanden Houte suggests increasing monthly purchases for the remainder of the programme looks to be the most effective option available to the ECB.
“Even if the ECB opts for the most credible QE option in its toolkit (increasing the size of monthly purchases over the remainder of the programme), its impact on the EUR is likely to be limited,” says analyst Petr Krpata at ING.
Earlier in the year, ING estimated that the one-off impact of the ECB QE programme on EUR/USD was worth around 7 big figures: 3.5 big figures priced in before the QE announcement, and another 3.5 big figures adjustment after the actual announcement.
The post QE-announcement adjustment occurred due to the ECB surprising the market. The ECB QE was twice as big in size compared with market expectations.
However this is unlikely to be the case time around - no one expects any top-up to QE to match the already existing 60BN i.e. we are taken to a new total of 120BN.
Indeed, how will the ECB be able to source new assets to purchase within the limited timeframe available?
ING say that if the original ECB QE sent EUR/USD down by around 7 big figures, the impact of an additional QE expansion on EUR/USD should be materially smaller given that:
(a) the increase in the size of QE would be meaningfully lower than the initial purchase programme and would be of a shorter duration (ie, less than 12 months, compared with 18-19 months);
(b) QE suffers from diminishing marginal returns; and (c) there is a limited downside to short-end EZ rates.
ING say the key channel through which the ECB QE II would impact EUR/USD is by passively keeping EUR lower (beyond the initial one-off, albeit limited, fall) rather than actively causing its depreciation.
“For EUR/USD to move meaningfully lower, USD needs to start strengthening boosted by the start of a somewhat hawkish Fed tightening cycle (ie, not a dovish hike),” says Krpata.
Unless this happens it is argued by the Dutch bank that EUR/USD downside will be limited by the lack of active USD upside.
“EUR/USD resilience over the past two quarters was largely a function of a lack of a move higher in US short-end rates,” says Krpata, “in the same time, USD TWI appreciation was caused by the collapse in EM and commodity currencies, rather than USD-induced strength.”