Divyang Shah, IFR Senior Strategist
Excess liquidity in the eurozone has fallen below €200bn to €187.4bn on Wednesday. A reduction in excess liquidity below €200bn is psychologically significant, but the ECB sees it as less relevant for monetary policy as it reflects reduced fragmentation in the banking system.
Still, the decline in excess liquidity will promote a steeper money market curve as well as further upside on EUR/USD.
Money markets to become more sensitive to decline in excess liquidity
While a very long term refi operation (VLTRO) and playing around with sterilisation of SMP are options that the ECB can use to keep excess liquidity from falling, these are likely to be kept in reserve should the AQR/stress tests lead to greater market instability. For now the ECB is likely to maintain that this is a positive development as it reflects a decline in fragmentation and healing in the money markets.
The evolution of excess liquidity will be a key driver for a steeper money market curve. We would look to take the view that the move on EONIA has gone a little too far and would now pay 12x24 EONIA at 33bp looking for a move back to around 55bp.
EUR/USD to focus on relative balance sheets
For FX markets the decline in excess liquidity, and thus a shrinkage in the ECB’s balance sheet, should help to provide further upside to EUR/USD. This is especially at a time when markets are positioned for the Fed to continue QE for the foreseeable future.
What has been interesting of late is the focus some ECB members have been giving to EUR strength and its impact on inflation. Further EUR strength makes it likely that inflation will be seen as staying low and thus in need of a response in the form of further monetary stimulus.
If the ECB were worried enough to act, the most likely option would be a further cut in the refi rate, which would help flatten the money market curve and support the ECB’s forward guidance.
But we have highlighted the breakdown in the correlation between EUR/USD and the slope of the money market curve (proxied by 12x24 EONIA) which suggests that any ECB action on rates would likely have limited impact on the exchange rate.
