ECB, Forward Guidance and the EUR/USD
This Wednesday, the ECB will continue to use its new communication tool to steer expectations on future monetary policy in the Eurozone. As ECB members have stressed several times, ECB-style forward guidance is about communication, not strategy: it remains conditional on the inflation outlook.
The implementation of forward guidance this summer was mostly motivated by external factors, namely the Fed tapering. Expectations of lower bond purchases by the Fed combined with the steepening of the US money market curve drove the Eonia and Eurodollar slope much higher - a pattern that could end up accentuating the freeze of the monetary transmission channel.
Of course, any endeavor to improve central banks communication when rates are close to the zero bound is welcome, but forward guidance is not only conditioned on some macroeconomic data (some kind of soft version of "we never pre-commit"), but also on the very nature of the mandate of a central bank.
Even though there are sound theoretical foundations for forward guidance, the implementation is not as straightforward as adopting a Taylor-like rule. Even though monetary policy in the 2000s has mostly been carried through constrained discretion (using rates for financial stabilization, for instance, as long as the primary objectives were not in jeopardy), it remained associated with some behavioral-type rules.
As any monetary policy tool, forward guidance requires a learning curve. For instance, it took several months for the Fed to deal with the internal contradiction of hastily-adopted guidance:
i. Bringing forward expectations of the first rate hike in repo rates;
ii. Without dampening future inflation and growth expectations.
To avoid reinforcing the risk of a liquidity trap (inflation expectations fall while short term interest rates are pegged at or close to zero, bringing up real interest rates), the Fed has adopted state-contingency operational targets - inflation close to 2% and unemployment below 6.5%. In spite of what Ben Bernanke has said many times, those thresholds would probably be triggers. This is clearly in line with the overall mandate of the Fed (inflation, maximum unemployment and reasonable rates).
The Fed therefore has the (limited) ability to talk up the economy without fearing an excessive steepening of the money market curve. This distinction of cycle and slope of the money market curve is welcome. The uncertainty remains on whether the trigger/threshold would be binding enough.
Interestingly enough, the ECB has implemented forward guidance before hitting the zero bound for the repo rate (0.5%). According to the ECB Bulletin, the aim is to reduce uncertainty on the forthcoming (conditional) path of monetary policy, regardless of the level of interest rates. Yet, in doing so the ECB remains within the "inner contradiction" mentioned before:
"It expects the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation continues to be based on an unchanged overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the economy and subdued monetary dynamics."
The ECB has much less room for maneuver in setting up intermediary targets. Of course, "without prejudice to the objective of price stability, the Euro system shall also support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union. These include inter alia "full employment" and "balanced economic growth." But it cannot reinforce the credibility of the forward guidance by providing numerical target (like the euro area unemployment rate) nor acknowledge improvement in the economy (or steering expectations upward) without lifting the slope of the money market curve.
In a recent speech given in NYC, Benoit Coeuré rightly stressed that in designing their forward guidance, central banks have been guided by the particular features of their respective economies and the specificities of their mandates. But even if forward guidance is conditional on each central bank's mandate, those same mandates might be a break from the full implementation of forward guidance, in particular on the operational side.
The last question is whether it has been useful.
i. The correlation between US and Eurozone money market curve slopes has not fallen dramatically, as can be seen in the chart below;
ii. The "control" of the curve is insufficient to avoid a sharp appreciation of the EUR/USD: the pair rose to a level much higher than what the OIS curve spread would imply.
This could be a source of disappointment for Eurozone GDP bulls since, as can be seen below, there is a negative link (looser over the last few quarters) between the external value of the euro (effective exchange rate, that is against main commercial partners) and Eurozone exports. A higher euro could clearly dampen the recent exports improvement even though part of the recent increase is linked to the slight rebound of global trade.
Beware: what matters for GDP growth is not so much exports than net exports (difference between exports and imports). The EUR/USD seems to be of secondary order here: whenever net exports are positive the Euro will strengthen (we doubt that net exports would be increasing as a result of a lower euro). This is clearly linked to the fact that the Eurozone has a structurally positive trade balance: the higher the balance, the lower the supply of euros, and the stronger the currency … For that reason we would not consider the recent rise of the EUR/USD as a genuine threat for the European recovery, even though it will undoubtedly constitute a headwind.
The recent course of the EUR/USD has left many investors unsettled. Both charts show how it has been difficult to gauge where fair value is:
i. PMI spreads suggest that the EUR/USD is well priced (if not slightly overvalued). The Eurozone might not be out of the woods yet, but the cyclical momentum for growth could continue until the end of the year at least, lifting up the PMI spread slightly higher by year-end.
ii. On the contrary, the ratio of balance sheets suggests that the EUR/USD is up for a stellar upward swing. Yet, as mentioned before, the fall in the ECB's balance sheet is mostly attributable to early reimbursement of VLTROs. As the ECB is concerned by a potential liquidity cliff at year-end and the potential consequences of the Asset Quality Review/stress tests (to be implemented in 2014) on the banking risk, a VLTRO 3 is on the card later this year. Even though it could be implemented at a time when the Fed starts tapering for real (December), we doubt that it would return some credibility to the broken relationship between EUR/USD and the ratio of balance sheets (for more please see seekingalpha.com/article/1667092-eurozon...) .
On top of this, my macro model for the EUR/USD (chart below left) suggests that the pair has not reached its upper level and that there might be some room for further appreciation. This is confirmed by technical analysis: the short term trend remains bullish after the break above August high pivot at 1.3450 with targets at 1.3711 (2013 top), possibly toward a long term resistance line (currently at 1.40). This area should cap the upside in the coming months.
Bottom Line: The implementation of forward guidance by the ECB adds to the arsenal of available communication tools in order to steer the money market curve. Using it before the zero bound for repo rates is reached means that forward guidance should not be seen as a non-conventional tool.
Yet, as I have shown above, the mandate of the ECB reduces somewhat the efficiency of forward guidance a l'européenne. For that reason, the de-correlation between US and European money market curves has not been as pronounced as expected. In addition, the EUR/USD has disconnected from the curves and its rise was not affected by the dovishness of the ECB.
The link between Eurozone GDP growth and the EUR/USD is not strong and straightforward. But the high probability of a slightly higher EUR/USD in the next few weeks adds a negative headwind on a European economy that remains crippled by the breakdown of the credit channel.