The European Central Bank (ECB) is expected to launch its quantitative easing (QE) program this week. While investors have priced in this monetary policy move, lots of questions remain concerning the details of that program. Will German opposition to sovereign bond purchases dilute the final program? Or will it be akin to those that we have seen from the United States and Japan? The answer will probably be somewhere in between. Due to the makeup of the European Union, the ECB cannot make unilateral decisions, especially when they contrast with the wishes of the influential German central bank. And yet failure to act as deflationary pressure mounts could further deteriorate economic conditions in the eurozone.
Mario Draghi has led the ECB through one of its darkest hours. His comments during the Greek crisis in 2012 served to define him as a transparent policymaker who values communication. Rhetoric has been his most effective tool as he has been limited by member opposition to use more traditional monetary policy alternatives. His “whatever it takes” pledge to defend the euro calmed the market, and without consensus on QE programs, he has openly urged member nations to reform their outdated market practices. After the Swiss National Bank’s (SNB) unexpected January 15 decision, market participants are looking for a better communicator than SNB Governor Thomas Jordan.
Interest Rate Divergence Pushes EUR Lower
The EUR/USD continues to fall as the market anticipates opposite interventions from the respective central banks. The ECB will launch a stimulus program increasing the supply of euros, while the U.S. Federal Reserve will launch a tightening program once it starts raising interest rates as early as the summer. The Swiss surprise announcement accelerated the euro’s decline against the USD, but further weakness is expected if the details surrounding the ECB’s QE program points to real stimulus.
Nevertheless, the ECB could disappoint the market, in turn hurting the growing short positions built around the current levels as the price reflects central bank action being imminent. An indecisive ECB and a patient Fed could combine for a higher EUR/USD.
ECB QE: What to Expect?
Given the comments from European officials such as French President Francois Hollande, and indirectly from German Chancellor Angela Merkel, an ECB QE program is almost guaranteed. Analysts have drawn various scenarios and although specific details differ, market expectations converge on €20 billion to €40 billion purchases each month, split between public and private assets. The sovereign bonds portion will most likely follow ECB capital allocation ratios.
SNB Reverberations Alarm Denmark
The SNB painted itself into a corner by having a hard target for the EUR/CHF currency pair. Given the cost of such a strategy, it needs to be backed up by hard currency, and the upcoming ECB QE announcement. Could the Swiss have removed their currency peg earlier? Yes. Could they have introduced other options such as a foreign-exchange band, or used their statements as forward guidance regarding their actions? Yes. The main reason they didn’t was that they lacked the full picture of the global economy, and went with a more risk-averse strategy (for Switzerland), in the hopes that their original program launched three years ago would not be as costly.
Given the situation the SNB faced, and with all the macro and global policy developments, there was only one option for the central bank: remove the cap. The time window available did not allow for a more sophisticated or gradual move. No wonder the decision was unanimous as time was of the essence. If they had more time they could have chosen an alternative option. However, some blame has to be placed on the leadership for not fully communicating the true state of the SNB’s thinking regarding the 1.20 euro cap sustainability.
The Danish krone makes for a natural comparison to the Swiss franc given its existing peg to the euro. The Danish central bank has already cut its interest rate into negative territory, –0.2%, the lowest since 2012 to keep the DKK weak versus the EUR. The country’s AAA-rating has attracted investors looking for stability, and further EUR weakness could cause the central bank to intervene first with a follow-up rate cut. The fact that the DKK is part of the European Exchange Rate Mechanism makes the peg more defendable as Denmark’s economy is more integrated with Europe’s, and at one point the country seriously considered adopting the single currency.
Central Banks and Growth Expectations Biggest Drivers of the Market
FX market uncertainty over central bank actions is high as the Bank of Japan, the People’s Bank of China, and the SNB have all gone off-script in the past three months. There are no surprises expected from the Fed or the Bank of England (BoE). For the ECB, it was simply a matter of when it was clear QE was needed to stave off deflation. Elections in the United Kingdom will be an event to follow later in the year given the precedent set by the Scottish independence referendum last year. What was supposed to be a known outcome with little consequence changed in a couple of months into a potential disaster with the head of the BoE cancelling a Group of 20 meeting at the last minute to be on hand if the Yes vote won the day. It didn’t, but it highlights the upcoming U.K. elections’ possible impact as it is forecast to be one of the closest races in decades.
The size of the move following the SNB shock announcement will probably not be seen again in a single trading day, but several events could have higher impacts in the mid- to longer-term. These include U.S. rates hikes, the U.K. election and a BoE rate hike, China’s economic growth and its impact on commodities, as well as the escalation of current military turmoil around the world.
Global growth got mixed indicators this week. China surprised the market with a higher-than-expected fourth-quarter growth rate of 7.4% when the forecast was 7.2%. Unfortunately, this is also the lowest quarterly growth in 20 years for China, now the world’s No. 1 economy. The International Monetary Fund dampened growth expectations further after it cut its global forecast to 3.5% for 2015, and China is not forecast to grow beyond 6.8% this year by the Washington, D.C.-based organization. Commodities latched on to the good news about Chinese growth, and the decline in prices stopped with copper and energy the big beneficiaries.
Draghi’s announcement on Thursday will mark a new era for the ECB. The growing anti-austerity movement across the eurozone shows that a single focus on reform cannot be achieved without stimulus. It is also worth mentioning that Germany’s Merkel has urged nations not to forget their reform promises and obligations despite any new stimulus measures being implemented.
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