How To Weaken The Euro

Includes: FXE
by: Evariste Lefeuvre

Economic Sentiment in Europe continues to worsen, pointing to a recession that may be more painful than expected by the Consensus. The EUR/USD reflect the dispersion between US and Euro cycles. As can be seen on the chart below, the potential for a weaker euro based on PMI trends is limited (the last point is based on consensus for US PMIs).

The ECB may act accordingly. The EU Summit failed to deliver any "growth compact." Anyway, there would have been implementation lags. Any 1% of GDP 'stimulus' would have come too late.

One solution to spur growth would be to weaken the euro. The timing would be beneficial to the eurozone economy, since commodity prices have collapsed recently (easing the risk of higher import prices). The question is how to do so, when the ECB is getting closer to the zero bound, and the expected monetary easing is already priced-in .

Could we expect a double whammy from the ECB? To bring euro-zone long-term interest rates back below the growth rate of each EMU member, the ECB would have to buy at least EUR 45 bn in government bonds per week: EUR 2,300 bn per year (almost doubling the size of the balance sheet).

In the chart below, I take a 'conservative' increase of 10 b EUR per week. It leads us to a sharply weaker euro.

The risk of such a strategy would not be inflation in the euro zone. It would rather be retaliation by other central banks (QE3), that would offset the impact on the EUR/USD, and spur a huge increase in global liquidity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.