EUR valued lower after Draghi comments

After Mario Draghi's oft-cited statement from July 2012 that the ECB would do "whatever it takes" to save the euro, Thursday's press conference was once again a testament of the ECB president's gamesmanship when it comes to stirring the markets in a desired direction by way of verbal intervention. The actual speech by Mr Draghi was mostly disappointing and interpreted by market participants as a sign of further ECB inactivity. It consequently sent the single currency from $1.394 almost up to $1.40 versus the US dollar, but during the Q&A that followed Mr Draghi apparently decided to be more concrete at last. In an answer to a journalist's question he said "the governing council is comfortable with acting next time" if necessary. EURUSD immediately dropped roughly one big figure to $1.39 and has since fallen further to $1.376.

This was the first statement by the central bank that explicitly referred to a concrete time horizon, signalling that the ECB may be in the process of preparing an intervention for June 2014. However, EUR sellers should keep in mind that this very statement is a factual intervention already and that it might render future actions obsolete if the euro continues to depreciate until the governing council's next meeting.

Playing the markets using nothing but words has worked rather well for the ECB so far, but hedge funds and other highly levered players now have a real incentive to force Draghi's hand. After all, if the euro resumes its climb and the ECB still does not act, the central bank will lose its credibility in the market. Draghi is certainly aware of this, which is why Thursday's forward guidance is also a powerful tool for traders who over the past weeks appeared unoriented with FX volatility close to historic lows: It has now become easier to forecast whether the ECB will act next month depending on the direction the EUR will go during the remainder of May and the first weeks of June. So the relevant question is, how long will the new dose of Draghi-talk last this time?

Thoughts on OMT, QE3 and EURUSD

On Thursday, 6th September, ECB president Mario Draghi finally gave the financial markets what they had long been greedy for: The European Central Bank announced its so-called Outright Monetary Transactions (OMT) programme, which shall provide it with the necessary and theoretically unlimited firepower to ease the euro crisis.

As had been expected, the adoption of this programme has not been unanimous with Germany's Bundesbank strongly opposing the decision and pointing at the risks associated with it. In fact, Mr Draghi et al. committed the euro zone to a massive gamble. Unlike the central bank's previous programme, known as Securities Markets Programme (SMP), the OMT does not have any quantitative limit, as made clear by Mr Draghi (quote from press conference transcript):

First, in terms of the size, I said there is no ex ante quantitative limit to these interventions because we want this to be perceived as a fully effective backstop that removes tail risk from the euro area. But, at the same time, if we achieve our objectives, why should we continue making these interventions? If governments or countries do not comply, why should we continue doing so? These are the two conditions for exiting.

This basically means the ECB will continue buying sovereign bonds as long as it deems necessary. While this statement might have temporarily softened the pressure on the single currency, in the longer term it implies severe risks for the euro area as a whole, because Mario Draghi's statement alone will not be sufficient to blow investors' fears away for good. Eventually the central bank will have to come through on its promises and actually buy bonds of troubled economies for as long as the crisis persists. Not too long ago, in order to avoid a bank run, Mrs Merkel promised German citizens that their personal savings would be safe. Similarly, Mr Draghi promises Europe and, as a matter of fact, the world economy, that the ECB is both willing and able to control the euro crisis. The only feasible way of keeping that promise, however, will be to print more money. This willingness to relax the central bank's formerly strict stance on money creation is what Jens Weidmann, president of the Bundesbank, and Axel Weber, his predecessor, have been opposing. Unlike Mr Weber, Mr Weidmann does not seem frustrated enough to quit, yet.

From Germany's point of view, the OMT programme comes with a few downsides: If the ECB will create money for the purchase of struggling economies' bonds, inflation risk increases and the real value of German savings might decline.

Additionally, German exporters might not be hedged sufficiently against the sudden appreciation of the euro. Nobody had really expected a move as bold as Mr Draghi's. Quite the contrary: German companies had likely been expecting a lower euro at the end of the year.

Finally, the programme is meant to fuel economic growth in the euro zone - it does not follow the road of austerity Germany has been pushing for. The long-term risk is that Northern European countries continue to take on increasingly large amounts of debt and at the same time transfer part of their wealth to their Southern neighbours. This strategy cannot guarantee success. Take Greece as an example. Despite the many billions of euros that have been given to Greece already, economic recovery of any kind is still not in sight.

More than one year ago, I wrote in the comments section of a blog post that Greece should default in an orderly way. While this would be painful for the Greek population in the short term, it would allow the country to put its own monetary and fiscal policies in place and inflate its debt away. After all, has any country on the verge of bankruptcy successfully been saved in the past? Will there ever be enough money in the world to rescue an entire economy? I'll leave these questions open for now, but I remain sceptic.

Another risk embedded in the OMT programme is its strict conditionality. Governments going to apply for OMT funds must commit themselves to austerity plans as per the EFSF/ESM programmes. Quote from the 6th September ECB press release:

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases.

Countries like Spain and Italy should therefore be less inclined to actually seek help, unless they ultimately have to. Secondly, countries that do agree to new austerity measures might not profit from the ECB's bond buying as much as hoped, considering that spending cuts and tax raises might at least partly foil the positive effects of OMTs. I have no doubt that this strong form of conditionality was introduced in an attempt to oblige German interests.

How did all this move the EURUSD exchange rate? Last week's steep euro appreciation, which was initially triggered by the ECB's OMT announcement, was further supported by Germany's Federal Constitutional Court ruling that the ESM bailout fund was not in breach of the German constitution and then by the US Federal Reserve announcing a new round of quantitative easing ("QE3"), in effect pushing US bond yields down and thereby putting pressure on the US dollar as investors seek returns elsewhere. The US dollar index, which tracks the dollar performance against a basket of other major currencies, closed at a four-month low on Friday. Much like the ECB, the Fed did not set a quantitative limit to QE3. Instead, Fed chairman Ben Bernanke said the Federal Reserve would keep buying $40bn of mortgage-backed bonds per month not just until it sees a substantial improvement in the labour market, but for a considerable time after the first signs of a stronger economic recovery. In addition, the Fed will keep the federal funds rate at extremely low levels until 2015. Details from the 13 September press release:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. (...)

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. (...)

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Taking this into account, the euro might well continue to increase in value against the US dollar by the end of the week, although a lot of the USD devaluation and euro zone stimulus should be priced in by now. Looking at the daily EURUSD chart, the euro is in overbought territory already, but considering that volume has been increasing, I can easily see EURUSD ascending into the 1.325/1.33 range before a consolidation kicks in. This would be about the same level from which the euro starting falling in May 2012.

In the meantime, market participants will surely look out for more details on how the ECB is going to handle its OMTs and specifically the austerity conditions associated with the programme.

On a related note with regard to the controversial topic of fiscal austerity versus growth stimuli, I read a very interesting editorial by Paul Kirchhof in yesterday's politics section of German newspaper FAZ ("Der steinige Weg zurück"), arguing that the growth of government deficits in Europe has given capital markets increased power over European governments. Indeed, the collective of financiers has a great influence on the rates at which countries can finance themselves in the capital markets and on whether they can do it at all. While this should be a sign of a functioning market economy up to a point, the anonymity of today's capital markets, with dark pools and largely automated trading, might prove problematic in future. When it is difficult to clearly identify certain agents in the markets and their influence on prices, both government regulators and politicians will find it harder to do their jobs properly. In fact, they will be forced to constantly react to the actions of agents in the market instead of being able to oversee or control them.