Will the ECB embark on quantitative easing?

In racing parlance, you slow down going into a corner and speed up coming out. 

Entering a corner at any speed does not guarantee a clean exit. For that, skill, patience and adaptability to adverse conditions are crucial. The crisis in the eurozone is certainly not as bad as it once was but, whatever you might have heard about turning a corner, this corner is something of a tricky hairpin.

Acceleration is sluggish

Eurozone growth momentum was barely positive in Q3 at 0.1% quarter-on-quarter, and Italy and France are still at odds in terms of GDP dynamics. In year-on-year terms, eurozone GDP is still negative (-0.4%) and the unemployment rate stands at 12.2% – a record high. There are currently 19.4 million unemployed in the eurozone, which is 6.8 million more than in 2008.

The combination of a strong currency and unemployment at these levels is something of a challenge for the European Central Bank. Even the last interest rate cut, which lowered the reference rate to 0.2% at the November meeting, had a weaker euro as its main aim.

Can recovery drive improved inflation?

The ECB’s actions have yet to restore a functioning interbank market in Europe, and it remains unclear whether the nascent recovery will be enough to lift the region out of dangerously low inflation. Eurozone money supply growth plummeted in October, with M3 money growth falling to 1.4% from a year earlier. This was lower than expected, and far below the bank's own 4.5% target deemed necessary to keep the economy on an even keel.

Loans to firms contracted at a record rate, heightening the risk of a stalled recovery and Japanese-style deflation next year.

Against the pound and the US dollar, the single currency displayed some weakness in the immediate aftermath of the cut. Yet the level of capital inflows into eurozone equity markets has been a major source of upward pressure.

ADP data may steer taper decision

As I write, we await the US non-farm payrolls data release. A strong ADP (Automatic Data Processing Inc) number showed 215,000 private sector jobs were added. This is up from 130,000 in October and topped analysts’ forecasts for a rise of 178,000. We can’t attribute any real correlation between the ADP and the non-farm figure,  as evidenced by last month’s massive divergence between a disappointing ADP and a stellar employment number. But it’s possible that the FOMC is examining all data points at this juncture as it considers its exit from the $85bn asset-purchasing programme. This taper tension has been the theme for the markets since May of this year, when the first threats emanated from Federal Reserve chairman Ben Bernanke. Clearly the opportunity to taper in September was not taken, as it was felt that this would knock sentiment too much when taken in conjunction with a government shutdown.

Fed action could apply the brakes

Despite an overall market improvement, the risks of a fallout from Federal Reserve tapering for the eurozone have already been demonstrated. Back in May, bond markets around the world fell sharply, especially in emerging markets. The ECB has already called on policymakers to ensure that institutional investors were prepared for a return to ‘yield normalisation’. One could argue that the macroeconomic policies of some member states may not be ready for ‘normalisation’.

Such uncertainty may mean that the ECB is highly unlikely to intervene directly in the currency market anytime soon, despite the fact that more action will be required if the bank is to avoid an excessively strong currency. The ECB will be hoping to play by the rules of its mandate for as long as possible.

Euro vying for leadership

The euro has outperformed against all G10 currencies in the year to date (4 December 2013) with the exception of the Danish krone, and even that has only seen gains of around 0.02% against the single currency.

If we look ahead to the coming year and the EUR/USD forecast based on analysis from 84 contributing banks, the median consensus is 1.28. Bearing in mind that the highest estimate is $1.45 and the lowest is $1.14, the jury is definitely out on whether the ECB can achieve liquidity in the interbank market. And it is also uncertain whether this liquidity will find its way into the greater economy through lending.

We may perhaps have passed the point where a member country might leave the single monetary union, but the chequered flag is not yet in sight.

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