Damned if they do…? | 19th January 2015
Why QE will not be enough for Europe | It is easy to view the Swiss National Bank (SNB)’s decision to drop its cap on the value of the Franc against the Euro as a harbinger of chaos to come. The immediate market reaction, pushing the Swiss Franc up by nearly 30%, arguably makes the currency case to support exporters less compelling for Quantitative Easing (QE). QE was always likely to depreciate the Euro, so if it has already depreciated, can it be justified on currency grounds?
We will probably never know whether the SNB’s decision was a Machiavellian one prompted by conversations held behind closed doors on the scale of QE to be undertaken by the ECB; nor will we know if it was insider knowledge of a concession to Germany: that individual sovereigns would be made responsible for their own debt. Heaven forbid, but the move could simply have been the SNB formulating policy on the basis of pure national interest. It would be possible to imagine a thought process that ran something like this: “If there is substantial QE, then there will be a run on the Euro. That will make it very expensive for us to maintain the cap and it will be better to have clarity now by instigating the drop in the Euro under Swiss-controlled conditions rather than leave it up to European policy makers.”
Who knows? But whatever prompted the move, it has done two things: first, it has thrown markets into confusion ahead of the ECB’s decision. In essence, unless the ECB introduces “substantial” QE, of say €1 trillion or more, the Euro could go into free-fall (if last week wasn’t free fall already). With this €1 trillion may well come conditions – Germany will not support QE if it means it is liable for others’ sovereign debt as the Eurozone’s paymaster and is likely to insist on the “concession” that sovereigns take responsibility for their own debt. A large announcement with strings attached is as bad for markets as a smaller announcement but with no strings attached: damned by markets if they do introduce QE.
But second, and more importantly for longer term Eurozone competitiveness, the move has also prompted more serious conversation on whether or not QE is the right thing to do for the Eurozone. It is not likely to be inflationary, not only because there is no evidence from the Bank of Japan (or indeed the Fed) that QE is inflationary, but also because oil prices have fallen so steeply that we are already in the throes of deflationary pressures if not outright deflation. While this may actually help producers, the fact is that it is arguably the perception of a threat of deflation that inhibits decision-making, not deflation itself.
What is clear is that the Eurozone needs to boost its demand urgently. Delta Economics is forecasting that intra-Eurozone trade will fall by 3.7% during 2015. This extends beyond oil prices because intra-European trade is predominantly in high-end sectors like automotives, pharmaceuticals, electronics & machinery. Markets know this and the Euro is therefore highly correlated over time with its trade at 0.84. In other words, month-by-month, if the value of the Euro appreciates against the US Dollar, trade in the short term will rise; if its value depreciates against the US Dollar trade will decrease (Figure 1).
Figure 1 | Monthly value of Eurozone exports, USDbn vs USD per Euro, last price monthly, June 2001-December 2015
Source | DeltaMetrics 2015
The strong association between trade and the value of the currency is counter-intuitive and needs some interpretation. Normally, a drop in the value of the currency would suggest a rise in exports, but in the case of the Eurozone since 2001, the reverse appears to be the case. Rather than a Euro depreciation improving trade prospects, it actually diminishes them. While this is not causal, what it clearly demonstrates is the relationship between the markets and the Eurozone: the Euro is a currency that is traded on the basis of the strength of the Eurozone as a trading bloc. Where the Eurozone looks weaker, so the value of the currency falls.
This does not augur well either for the prospects of growth in the Eurozone or for the value of the currency. It certainly leads to the conclusion that more is required to boost Eurozone demand than simply purchasing government debt, indeed that QE may well be too little, too late. Falling oil prices may well provide a boost to companies by reducing producer prices but without strong demand in Eurozone there is little that producers can do to take advantage of low prices and low borrowing costs.
The days ahead of the announcement will be dominated by uncertainty and volatility for markets and businesses: that much is clear. Ahead of the announcement it is likely we will see further depreciation of the Euro to test the tensions between Germany and the ECB on further austerity measures. Alongside further drops in oil prices and perception of a deflationary threat, the uncertainties that this creates for business are manifest.
And this is the real paradox of ECB policy at the moment: if it instigates wholesale QE then it will prompt further depreciation of the Euro – whether it is unconditional or not. With conditions if the rumours prove true, the run on the Euro may start earlier. And yet, if the ECB decides to go for a smaller-scale QE or no QE against market expectations but to spend money on infrastructure instead, then there will also be a run on the Euro: damned if they do, and damned if they don’t.
Damned if they do…?: Why QE will not be enough for Europe | Trade View Author | Rebecca Harding | CEO