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Euro at Risk as ECB Faces Few Choices

Last updated 4/1/2009 12:33 PM ET (GMT -5) 0 Comments - Add your comment

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Boris Schlossberg

Director of Currency Research, GFT

 Tomorrow the ECB is expected to lower rates by 50bp bringing the overnight rate to 1%. Given the gloomy recent economic data t from the region, the rate cut seems almost pre-ordained. With EZ unemployment rising to a three year high of 8.5% while retail sales in Germany, the union’s largest economy, contracting  by another  -0.2%, the situation on the ground remains grim. Therefore the markets are pricing in a 100% possibility of a  50bp cut.

Of course the notoriously hawkish ECB could shock with its typical gradualist approach by lowering rates by only  25bp, but given the collapse of the labor market and the near total absence of price pressures (latest CPI data from Germany was actually negative -0.1%) the ECB has little reason to remain restrictive. We have always argued that ECB monetary policy is highly sensitive to labor conditions and therefore  we believe that the consensus view is correct.

What to expect from ECB

Although tomorrow’s  rate decision carries little suspense, the markets will  watch Jean Claude Trichet  post announcement press conference with keen interest focusing on three critical questions.

1. Now that rates have reached 1% (assuming 50bp goes into effect) will ECB begin to implement “unconventional measures” ?

Unconventional measures is simply policy speak for quantitative easing. Unlike its G4 counterparts   the ECB has been reluctant to engage in quantitative easing (using its balance sheet to buy bonds) for several reasons. First and foremost the Eurozone does not have its own bond. If the ECB were to follow the path of the Fed or the   BoE it would have to chose between buying German, French, Italian or other member sovereign debt and such a policy move is politically dangerous. As one unnamed ECB official recently noted to Market News International, “government bond purchases are fraught with risk, carry high costs for taxpayers, and could jeopardize the independence of the central bank.”  

Since the majority of financing in the EZ takes place through bank loans rather than capital markets, the ECB is much more inclined to simply extend   the terms of its fixed rate full-time allotment tenders from the current period of six months to a year. This would provide European banks with more time to use the capital  and is much more in line with ECB preferred “credit easing” policy rather than pure quantitative policy of the Fed, BoE and BoJ.  

Nevertheless, as recent economic data shows, current monetary policy measures have had little success. That is why ECB is seriously considering buying financial assets to complement its current initiatives. In ECB’s case however, the assets in question are likely to be corporate bonds rather than sovereign debt.    

Unless the ECB council has fully agreed on this course of action, it is highly unlikely that President Trichet will discuss the idea in detail. Still if he simply mentions the fact that the central bank s is open to the possibility of buying assets outright, the euro could come under pressure. The unit staged a strong rally following the QE announcements from the Fed and the BoE as traders flocked to the one G4 currency that was not being debased. However, if Mr. Trichet suggests that some form of QE is coming the euro will lose its unique appeal to the market and could weaken materially given the horrid fundamentals in the EZ.       

2.       Is 1% the floor for ECB rates?  

Again standing apart from its G4 colleagues, the ECB has been   extremely hesitant to take interest rates near the zero level. For months ECB officials have hinted that 1% would be the end of the rate cutting cycle with Trichet himself saying that lowering rates to zero would not be “appropriate.”  Instead , European monetary authorities kept the deposit rates at ECB at a very low 0.5% - in effect discouraging banks from  keeping their funds inactive at ECB. Therefore in its own passive way the deposit rate has become the barometer of borrowing costs in the region and the central bank is likely to lower it once again to 25bp in all practicality bringing it in line with zero.  

However, again despite their best efforts ECB’s monetary easing has not been stimulative enough for the economy. The central bank may have no choice but to consider lowering the overnight rate below 1% barrier if conditions in the EZ deteriorate further.  

3.       How will the ECB deal with credit crisis in Eastern Europe?

One of the key factors that has contained euro’s in the past month rise has been the  market concern over the credit crisis brewing in Eastern Europe where consumers and corporations borrowed heavily  in low yielding Swiss francs and euro s rather than their own high interest currencies. The credit crunch triggered massive capital outflow  from  those nations cutting the value of their currencies by as much as 50%. Faced with the prospect of servicing loans that are in effect twice as large as when they first took them out, many East European borrowers may now default putting Western banks that extended this credit at serious risk.     

The ECB has limited authority to deal with this problem, but one novel idea that been proposed is that the central bank intervene in the FX markets of the  Eastern European economies, in effect propping up their national currencies by selling euros against them. Because the economies of these nations are relatively small, the ECB would have the scope to stage a credible intervention and could mitigate the crisis by boosting the value of local currencies and making the servicing of the current loans much more affordable. The net impact however could be negative for the euro as intervention would create a natural supply of the currency.    

In summary, as traders await the ECB decision the preponderance of evidence suggests that the euro may come under further pressure should ECB entertain the idea of quantitative easing or additional reductions in overnight rates or even a some form of   currency intervention in Eastern European markets. Given the severe deterioration in EZ labor market s, the ECB may not be able to avoid any of these unpleasant choices leaving the euro vulnerable to   more downside pressure. Going into the announcement short EUR/GBP remain our favorite strategy to play euro weakness as interest rate differentials between the two currencies continues to compress and euro valuation against the pound reverts to the mean.          

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.