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Ballooning ECB Balance Sheet to Sink Euro in Q1’15

DailyFX.com –

The Euro’s performance in Q4’14 captured perfectly the essence of our Q4 forecast title: “deflation pressure stack up against ECB, Euro in Q4.” On the inflation front, the situation could not have gone worse: the ECB’s preferred market measure of inflation, the 5Y5Y forward breakeven rate, closed the first week of December at 1.608%, below the ECB’s medium-term inflation target of 2%. Before the ECB’s last meeting of 2014 on December 4, the 5Y5Y swap fell to as low as 1.429% – perhaps the most significant piece of evidence suggesting that a Japanese-like ‘lost decade’ has descended upon the Euro-Zone.

The economic backdrop entering Q1’15 remains the biggest impediment to the Euro as evidence of a protracted economic slowdown and plummeting inflation expectations have cropped up. Based on what we’ve heard from various ECB officials, the weak state of economic affairs (combined with zero thrust among fiscal policymakers to do anything constructive) could necessitate the next iteration of ECB easing as soon as Q1’15.

This time is different, however: while market participants call for a Fed-styled, sovereign QE program, the ECB recognizes it would be ineffective given the fact that peripheral yields have plummeted across the region. Instead, focus should be on the size of ECB’s balance sheet.

The most significant development that will happen in Q1’15 is that the ECB will decide whether or not that the current easing measures (interest rate corridor in negative territory, TLTROs, ABS-program) are sufficient enough to drive the balance sheet back towards its early-2012 levels (oft-cited by ECB President Mario Draghi and ECB VP Vitor Constancio). The end goal for the ECB is to increase excess liquidity levels in the region, in the hopes that banks’ buffered balance sheets will allow them to increase lending activity.

To this end, our focus for Q1’15 is if the ECB will act once more to accelerate its balance sheet’s climb back to those early-2012 levels – which, as it stands, would result in another €500 billion to €1 trillion in asset purchases. Sovereign QE is merely one of the routes that could possibly be traveled to achieve this goal; but it is not necessary. The prospect of a QE program – not just sovereign but anything that boosts the size of the ECB’s balance sheet – should be sufficient enough to keep the Euro pinned lower over the coming months.

EUR/USD Cycles Point Lower in Coming Months

The 4th quarter saw more weakness in EUR/USD as the exchange rate fell to its lowest level in over two years. The break of key long-term retracement levels at 1.2800 and 1.2450 (61.8% and 78.6% of 2012 – 2014 advance) was quite significant technically and serves as further confirmation that an important decline is underway in the euro. General weakness in the rate is favored through the 1st half of 2015.

The 50% retracement of the all-time low and all-time high near 1.2100 should prove to be an important pivot in 1Q15 with weakness below needed to maintain downside momentum and set the stage for a deeper decline towards 1.1800 and possibly 1.1200 in 2015. Resistance at 1.3150 is now critical and only a move over this level would turn attention higher in the single currency.

Our cyclical analysis indicates that late January and late February should prove important for the exchange rate from a timing perspective.

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Ballooning ECB Balance Sheet to Sink Euro in Q1’15

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Written by Kristian Kerr and Christopher Vecchio, Currency Strategists for DailyFX.com

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