Article / 09 March 2018 at 0:18 GMT

ECB reduces emphasis on balance sheet in favour of forward guidance

Managing Director / Technical Research Limited
New Zealand
  • EURUSD reverses knee-jerk gains as cooler heads prevail
  • ECB sensitivity analysis projects EURUSD rising to 1.42
  • German bond free-float less than 10%, says ECB

By Max McKegg

When the European Central Bank’s monetary policy statement popped up on FX traders' screens on Thursday, the knee jerk reaction was to push EURUSD up to 1.2445. Previous assurances that the bank was “ready to increase the asset purchase program” if inflation progress faltered had been removed. 

Cooler heads prevailed as the day wore on and EURUSD declined towards 1.2300 as the US trading session drifted to a close. A closer reading of the statement, supported by clarifications by ECB President Mario Draghi in his press conference, made it clear there has been a change of tack rather than a change of course.
 
That change of tack is shifting emphasis away from asset purchases to forward guidance as the main monetary policy tool (for reasons outlined below).
 
As background, the ECB staff macroeconomic projections show the inflation track little changed from their December report. Headline inflation will rise to 1.7% by 2020 which, at a stretch could be considered “below, but close to” the Governing Councils 2% target. The projection for 2019 was dropped from 1.5% to 1.4% due to the impact of a rising EUR.
 
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Source: European Central Bank
 
As usual, the staff projections assumed the exchange rate would hold steady throughout the two-year projection period, that is 1.24. But they provided a “sensitivity analysis” around the assumption whereby EURUSD would gradually rise to 1.42 “driven by continuously improving investor sentiment in favour of the euro”.

Under this alternative path for the exchange rate, headline inflation next year would drop to 0.9% and rise to only 1.3% in 2020. Note that this assumes the rise to 1.42 would be “a purely exogenous exchange rate shock”, in other words, caused by a falling USD rather than an upward movement in the EUR due to improving economic conditions.
 
Of course, it’s the overall movement in the value of the EUR that is important, not just EURUSD. This chart (click to enlarge) shows the alternative path for the effective exchange rate, otherwise known as the trade-weighted index.
 
Euro effective exchange rate
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Source: Metastock
 
Taper tantrum euro style
 
With Eurozone bond yields still languishing at low levels, some analysts are predicting a taper tantrum when the ECB finally decides to begin winding back its balance sheet. After all, as this chart shows, the ECB already owns about a quarter of the government bonds issued by Eurozone governments, quite a bit more than the peak achieved by the US Federal Reserve. What will happen when the ECB pulls out of the market?
 
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No need for concern, according to executive board heavy-weight Benoit Coeure. In a speech a couple of weeks ago he claimed that the bank had a virtual stranglehold over the bond markets, so much so that the “free float” of German bunds, after taking into account ECB holdings plus those of foreign central banks, is less than 10% of issuance. 

He said: “The amount of bonds available to private investors is currently so low that investors are willing to absorb new bonds without requiring much higher compensation ... Only very large changes in the expected supply of bonds can cause yields to rise more meaningfully."
 
As any poker player knows, if your pot is much larger that the other players combined, you control the game.
 
Coeure makes the point that the Federal Reserve never achieved this dominant position, and hence had no control over the temper tantrum that drove yields up sharply on the suggestion bond purchases might be wound back.
 
The ECB is top of the heap because its purchases have been significantly larger than net new issuance by Eurozone governments. That wasn’t the case in the US.
 
According to Coeure, the ECB is now in a position where it can “retreat as a buyer in the market without risking an unwarranted decompression of the term premium”. The term premium is the extra yield investors require to compensate for the risk of holding longer dated bonds. 


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Still on course ... A reading of the ECB statement, supported by Mario Draghi's comments, showed there had only been a change of tack rather than a new direction. Photo: Shutterstock

But investor expectations of future short-term rates are also built into bond yields, so the ECB can contain volatility – and safeguard appropriate financial conditions – only to the extent that it provides effective guidance on the expected future path of short-term interest rates”.
 
That’s what Thursday’s monetary policy statement and Mario Draghi’s press conference was all about.
 
With the ECB “sitting on” the Eurozone bond market, local investors may look longingly at the high yields available on US treasuries, but rising hedging costs mean they are better off keeping their funds at home. 

A 10-year German bund yields 0.65% compared to the US equivalent at 2.85%; on the face of it a 222 basis point pick up, not far from the record 230 basis points seen a year ago. But if Eurozone investors wanted to hedge the resulting EURUSD exposure for 12 months, they would have to borrow US dollars at 2.50% through the FX forward market while earning minus 0.20% on the euros they handed over in exchange, a total cost of 270 basis points. 

Add in the cross-currency basis of 30 basis points – the extra cost of doing the transaction because everyone is coming from the same side – and you have a total hedging cost of 300 basis points.
 
Not much point then in buying a US bond at 2.85% and paying 3% to hedge it. Better to just stick with bunds – or buy the US bond unhedged, taking on EURUSD exposure.

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
09 March
Patto Patto
At least the ECB meeting generated a bit of action. The much anticipated Bank of Japan statement read exactly the same as it has for the last 6 months.

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