FYI | Sep 05 2014
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
Actions speak louder than words, the ECB found out today. Since the ECB announced its decision to cut rates and buy asset-backed securities, EURUSD is down more than 1.5%, and is one of the worst performing currencies out of the majors.
Although the ECB only cut interest rates by 20 basis points, pushing the base rate down to 0.05% and the deposit rate down to 0.2%, and we won’t find out further details of the ABS programme until next month, today’s actions suggest that the ECB has a plan to deal with recession and deflation fears. The first step of its plan actually took place in June when the ECB touted the prospect of an ABS purchase programme and also made its initial rate cut. The second step was last month at Jackson Hole when President Draghi touted the prospect of QE and sounded genuinely concerned about the decline in long-term inflation expectations. Draghi and co. took their next step today, by actually announcing the details of the ABS purchase programme and making another cut to interest rates.
Whether or not there are further steps in this process we shall have to see, but Draghi said that should further risks of “too prolonged a period of low inflation” materialises, the “Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate.” This appears to leave the door open to full blown QE if the inflation situation does not improve.
Details of the ABS programme:
- Draghi said it was difficult to determine the potential size of this programme at this early stage.
- It will include assets that are “simple and transparent”, and will include loans to businesses/ individuals.
- More importantly, the ABS programme will include covered bonds, a debt instrument backed by cash flows from mortgages or public-sector loans. This could be designed to help countries that experienced housing market bubbles like Spain and Ireland.
- Draghi let slip during the Q&A that these bonds will be guaranteed – we still need to clarify this point, but we may need to wait until next month to get more details.
The ABS market has more than halved since 2009, however this is still a radical step for the ECB, since, at this stage, its size is unlimited. The other major asset purchase programme that was unlimited was QE3 from the Federal Reserve, so is the ECB becoming Fed-esque?
We may need to wait until next month to see if the ECB is following the Fed, albeit with a long lag, for now the ECB has to keep the door open to further action as it is at risk of missing its mandate to maintain price stability. The latest ECB staff forecasts are also worth noting:
- Growth forecasts were revised lower for 2014 and 2015, while the outlook for 2016 was revised higher.
- The inflation forecast was revised down to 0.6% for 2014, but remained the same for 2015 and 2016.
- The risks to growth remain to the downside.
- Although the ECB expects inflation to moderate in the coming months, the Bank still expects inflation to rise during 2015 to 2016.
The bank may be able to avoid further action if the 2015/16 inflation outlook remains stable, thus we don’t expect any new measures until we get the next set of ECB staff forecasts that will be released later this year.
Waiting for the minutes
When the ECB takes big decisions, like it did today, it makes you wish that the Bank released minutes to fill us in on how the decision was made. Draghi said that the decision was not unanimous, and a member of Angela Merkel’s Christian Democratic Union said that they took a “critical view” to the rate cut.
As we mention above, today’s move was the culmination of a long planning process that began in May when the ECB first signalled it was ready to embark on a monetary loosening programme. Today’s announcement was likely to be the result of careful negotiation on the part of Draghi. If we can assume that Germany, who has been against asset purchase programmes in the past, may have reached their limit with the ABS purchase programme, then the bar to QE could be extremely high.
PS, we only have to wait a few more months until the ECB starts releasing minutes from the start of 2015.
The market reaction
Draghi and co. can celebrate a small victory over the markets – the rate cut/ ABS purchase combo helped to sink the EUR, which is even falling against the Ruble. EURUSD sliced through key support levels at 1.3105 – the September 2013 low – and then 1.3025 – the 32.8% Fib retracement of the 2012 – 2014 bull trend. Once 1.30 was breached the market continued to push this pair back into territory that was last broken in July 2013. Back then EURUSD fell to a low of 1.2746 – the low from April 4th 2013, which is now a key level of support.
From a strategic view point, today’s move could signal that the next leg lower into 1.20’s territory is now upon us. Although EURUSD has fallen consistently since April, there is still a fundamental reason for further downside, as we don’t know how large the ABS programme will be and the door to QE has been left open. Both of these programmes could cause the enlargement of the ECB’s balance sheet, we know that there is a link between a growing central bank balance sheet and a falling currency, thus the market may continue to price in the prospect of a larger balance sheet (weaker currency) for some time yet. As you can see in the chart below, the expansion of the Federal Reserve’s balance sheet coincided with a period of USD weakness, the same may happen for the EUR, although the link between the two is not always perfect.
In the very short-term, we could see some pullback as we wait for the next major fundamental event for this pair, Friday’s Non-Farm Payroll report; however, the market may fade any upside. Key short-term resistance lies at 1.30, then 1.3025 – the 32.8% Fib retracement of the 2012 – 2014 up-trend.
Now you can follow us on Twitter: http://twitter.com/FOREXcom
Re-published with permission. Views expressed are not by association FNArena's (see our disclaimer).
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.
Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Conduct Authority (FCA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan. Please read Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/about/publications/character-risks.jsp).
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
