Sara Yates , Global Head of FX Strategy, J.P. Morgan Private Bank ECB and the Fed continue to act very differently You have probably all heard of the book "Men are from Mars, Women are from Venus". But if you weren't one of the 50 million people who (according to Amazon) bought a copy, a main theme of the book is how different people can respond very differently to the same situation. The same is true of Central Banks . For example, while the Fed aggressively loosened monetary policy throughout the euro area crisis, the ECB was more often found quibbling over the level of inflation and even hiked rates twice in 2011! As a result, JPM Investment Bank believes ECB policy is currently 150-200bps TOO TIGHT for the euro area's economic outlook, while the Fed's policy is TOO LOOSE. If you want proof of these different central bank reaction functions, you need look no further than the level of EURUSD. It remains strong at 1.36 and even at the height of the euro area crisis, EURUSD barely managed to dip its head below 1.20! ECB is unlikely to drive the EUR lower with a deterioration in euro area conditions Euro area inflation is low and growth is weak. But, arguably, the ECB already reacted to that environment when it cut the refi rate to 0.25% last November. Unless this environment deteriorates from here we feel it is very unlikely that the ECB will loosen policy further. We believe Draghi confirmed our view at last week's ECB press conference when he stated that the ECB would act IF (and only IF) one or more of the following conditions are met: 1) The inflation outlook worsens. In other words, if inflation starts to trend lower, rather than just being low. 2) If there is an unwanted tightening at the short end of the money market curve. This suggests that the EUR is unlikely to move lower on ECB policy at this point. Moreover, as we saw at the end of last year, tighter money market conditions push the EUR up. This suggests that if scenario 2 occurs, the EURUSD is likely to go up first. How could the ECB loosen policy? The ECB has a number of options it could use to loosen policy. We examine each in turn. Refi rate cut: The refi rate is 25bp and could be cut further, say to 12bps. As we saw in November, the signalling impact of such a move is a near term negative for the EUR. But as a cut in the refi rate is also growth positive, the weight on the EUR is short lived. Rather, in our opinion, such a cut would be more successful at limiting the upside for the EUR as it would further narrow the corridor in which the short end of the money market curve trades. We think this is a feasible response if either scenario occurs. LTRO: We strongly believe that another successful Long Term Repo Operation (LTRO) would flood the system with liquidity and push down the EUR. However, with banks already paying back the existing LTRO it is not clear to us that there would be strong take up for this type of measure. Moreover, we believe the main challenge facing the euro area is credit availability (not liquidity). Because of this, many market commentators have suggested that if the ECB was to do another LTRO, the money would come with conditions attached. In a sense, it could transform the LTRO in to a type of UK Funding for Lending Scheme. If so, the impact on the EUR would be more ambiguous, in our opinion. First, its effectiveness is likely to be questionable, as just like in the UK , the banks that would benefit most from the scheme are likely to already committed to deleveraging their balance sheets. Second, easier credit conditions typically support an economy and its currency. For this reason, we remain unconvinced about the likelihood of another LTRO. Moreover, we feel it is only likely to result in modest downside for the EUR if delivered. Negative deposit rates: The deposit rate is currently 0%. To cut it from here would mean having a negative deposit rate. As it is the deposit rate that anchors the yield curve, a negative deposit rate would pull down the whole curve and the EUR. However, as this would be unchartered territory for the ECB, we continue to think it is an unlikely option. Change in SMP rate: The ECB soaks up the liquidity created by the securities market programme (SMP) through weekly SMP operations. Currently, the rate at which the sterilisation occurs gets bid up to the refi rate (25bps). The ECB could change this rate to hold down the short end of the money market curve and limit the upside for the EUR. Our impression is that while this is technically feasible, it would be seen as QE through the back door and is therefore unlikely to gain traction within the ECB. QE. Were the ECB to follow the Fed and start a Quantitative Easing programme (QE), it would debase the EUR. We think this is an incredibly unlikely outcome, given German opposition. If ECB policy is unlikely to have much of an impact on the EUR, what else matters for EURUSD? US yields. The Fed announced it will start tapering this month and as this occurs we expect US yields to rise further. The question though is how much further will 10y yields rise this year? In our opinion, not much. The US curve is already very steep. If US 10y yields reach 3.5% by year end without a move in the short end, the steepness of the curve's steepness would be at a historical extreme. This suggests that technical factors will inhibit a stronger, isolated rise in 10y yields, limiting the support this part of the curve can give the USD. What we think is feasible, is that a continued run of strong US data undermines the Fed's ability to anchor the short end of the curve and the 2-5y part of the curve pushes higher. With low inflation in the euro area likely to keep the ECB on hold for some time, the move in the short end of the US curve would push EURUSD lower. Structural issues. The US's twin deficits have helped the USD underperform its developed market pals for decades. But this is changing. Progress on the budget negotiations are helping to improve the fiscal deficit. Similarly, the shale oil/gas revolution has already brought meaningful improvements to the current account, and last week's November trade deficit printed the lowest for four years. This trend seems likely to continue and is a reason we are long term USD bulls. But as the current account dynamics for the euro area are also positive, the structural support for the USD versus the EUR is ambiguous, in our opinion. EUR inflows. With the euro area recovery in train, we expect demand for EUR denominated assets to increase, supporting the EUR. So what does all this mean for EURUSD? It means that in the red corner we still have USD positive factors and the in the blue corner EUR positive factors are as strong as ever. As these battle it out, EURUSD is likely to bump around within a 1.38-1.32 range. About J.P. Morgan Private Bank : With client assets of $909 billion , J.P. Morgan Private Bank is a global financial leader providing advice and customized solutions to wealthy individuals and their families. The firm leverages its broad capabilities in investing, tax and estate planning, family office management, philanthropy, credit, and special advisory services to help our clients advance toward their own particular goals. For more than 160 years, the Private Bank's comprehensive and integrated approach, commitment to innovation and integrity, and focus on client service have made J.P. Morgan the advisor of choice to those of significant wealth around the world.
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