The European Central Bank is set to formally launch its program of quantitative easing (QE) in the coming days. With the program’s key parameters already widely known, its impact might seem to be largely “priced-in” by now. Still, Europe’s QE should not be underestimated. A comparison with the Japanese yen’s trading pattern two year ago, and the sheer size of the program, suggest that the longer-term devaluation process is still far from over for the euro.
Tomorrow, ECB is expected to communicate further details and procedures of its QE program, which was officially announced on 22 January. Unless the central bank unexpectedly comes up with additional easing steps at, which we do not view as likely, financial markets would seem to have by now largely priced in this development, at least for the time being. Nevertheless, in the bigger-picture, the euro maintains a significant devaluation potential against most other major currencies.
Since the day of the official QE announcement by the ECB, the euro has lost about 3.7% against the US dollar, which corresponds to an annual pace of depreciation of about 28%. In the six months before the announcement, the euro had lost 14.2%, or about 26% per year. Hence, the euro’s depreciation rate against the greenback has accelerated slightly since QE became fact.
This pattern of accelerated depreciation is generally valid against most other major currencies, and particularly evident against the British pound. In the six months before the ECB decision, the euro shed 3.2% against Sterling, i.e. 6.3% per year. Since then, however, its fall has accelerated to 5.1%, or 37% per year. Against Japan’s yen, the euro lost 0.1% (0.2% p.a.) in the six months until 22 January, but dropped by another 2.4% (19% p.a.) since. Similar trading patterns can be observed against most other currencies, with the notable exceptions of the Swiss and Scandinavian currencies, which represent special cases.
This pattern of an escalation of the existing trend shortly before a widely-anticipated event indicates that euro’s current selloff can last for a little while longer - until investors’ positioning become too extremely one-sided, and the downtrend exhausts itself. The yen’s trading pattern in the run-up and aftermath of the actual launch of the Bank of Japan’s QE announcement on 4 April 2013 offers an interesting precedent in this regard (see chart 1, page 2). The yen, which had already been depreciating for many months, continued to fall for about six weeks following the launch of QE. But then followed a phase of consolidation and relative stability, which lasted for about half a year. Another year had to pass before the next significant devaluation move began.
Finally, it is worth adding a word on the magnitude of Europe’s QE. Many analysts still seem rather skeptical about its potential effectiveness, arguing that it comes relatively late, is too conservative in design, or that the euro area is simply too different from the other QE economies. Our view is that the ECB’s effort should not be underestimated. Compared to gross domestic product (GDP), the announced 60 billion euro of monthly bond purchases might look modest by global standards. However, if we compare the ECB’s planned purchases to the region’s fiscal deficits, the size of Europe's QE clearly trumps all other programs (see chart 2, page 2).
The ECB’s QE will thus provide support where the Eurozone governments not only need it most, but which also happens to be the area where Europe is actually better off than the other countries when they launched their respective QE programs. In other words, the fiscal space for growth-friendlier policies in Europe today is greater than it was in the US and UK in 2009, or in Japan in 2013. Hence, if Europe’s governments utilize this opportunity, which is reasonably likely, chances are that Europe’s QE will ultimately prove very effective. At the same time, the magnitude of Europe’s monetary easing effort will continue to weigh on the euro for quite some time to come.
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Note: The next LGT Beacon will be published on 11 March 2015.