European Central Bank keeps its options open ahead of US rate decision

ECB buys some time to see which way the Fed jumps

PUBLISHED : Sunday, 06 December, 2015, 10:00am
UPDATED : Sunday, 06 December, 2015, 10:00am

The euro may have gained ground after Thursday’s European Central Bank (ECB) policy announcements somewhat underwhelmed a foreign exchange market that was running short of euros on expectations of “shock and awe”, but the rally will probably not last.

The ECB’s cutting of its deposit rate to minus 0.3 per cent from the existing minus 0.2 per cent, meaning depositors pay yet more for the privilege of parking their euros with the central bank, is hardly going to encourage Asian investors to add more euros to their portfolio, even if the cut came in at the lower end of currency market analysts’ expectations.

As the cut merely lends itself to even lower euro zone government bond yields, it will not be attractive to Asian central banks’ reserve managers for whom negative yields are, by definition, anathema.

Indeed, the bounce in the euro’s value might even tempt some to reduce their exposure to the single currency.

And who could blame them?

The euro is the constituent that has been reined in the most to help accommodate the inclusion of the yuan

The International Monetary Fund’s (IMF) November 30 reconfiguration of the constituents of the Special Drawing Right (SDR), it could be argued, was no vote of confidence in the euro.

Within the SDR, the new respective weights for the five constituent currencies, effective from October 1 next year, will be the US dollar 41.73 per cent, the euro 30.93 per cent, the Chinese yuan 10.92 per cent, the Japanese yen 8.33 per cent and the pound sterling 8.09 per cent.

The prior weightings, before the yuan was included, were the US dollar 41.9 per cent, the euro 37.4 per cent, the Japanese yen 9.4 per cent and the pound sterling and 11.3 per cent.

It does not take a Nobel prizewinner to realise that the euro is the constituent that has been reined in the most to help accommodate the inclusion of the yuan.

Indeed central banks who might wish to start mirroring their own reserves to match the new SDR configuration might logically conclude that one of their first steps might be to sell a few euros versus the yuan.

Such players might also rationally conclude that the ECB may have chosen on Thursday to keep something back in terms of its monetary policy toolkit. Reserve managers know better than anyone that no central bank ever wants to be seen to be running short of ammunition as it seeks to achieve its monetary policy objectives.

“Our asset purchase programme is flexible. It can always be adjusted,” ECB president Mario Draghi said on Thursday.

That does not sound like a man who thinks he is all out of options.

The ECB may also have one eye on the US Federal Reserve’s Open Market Committee meeting from December 15 to 16, at which the Fed may finally choose to raise US interest rates having reduced them to near zero seven years ago.

“Were the [Fed] to delay the start of policy normalisation for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals,” Federal Reserve chairwoman Janet Yellen said on Wednesday, ahead of the ECB’s meeting.

That sounds like a woman preparing to articulate the arguments for an increase at the Fed meeting.

Given that there are known differences among member countries about the need to ease euro zone monetary policy further, Thursday’s decisions may have enabled the ECB to paper over the cracks while buying some time to see which way the Fed jumps.

If the Fed tightens and the US dollar rises, some at the ECB might argue that the subsequent weaker euro, by encouraging imported inflation into the currency bloc, might do some of the ECB’s work for it.

If the Fed stands pat, or even if the Fed increases and the US dollar fails to gain much traction, the ECB could choose to consider further monetary easing which would , by extension, lessen the attractiveness of the euro for international investors.

But perhaps the key issue for investors in Asia, as we approach the end of 2015, is which currency feels right to hold, and which currency doesn’t. Have the arguments in favour of the US dollar over the euro really changed?

Painful as they may be, the euro’s post-ECB rally was in truth, arguably, largely driven by position adjustments, and that does not necessarily reflect the true picture.

In the cold light of day, there remains a strong argument for the euro’s rally versus the US dollar to fizzle out in quick fashion.