EUR Slides as ECB Fails to Impress

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Today’s European Central Bank monetary policy announcement was a disappointment. The ECB left interest rates unchanged at 0.75% and introduced a whole new set of acronyms that sounded glamorous on paper but was lacking in pizazz. Outside of keeping interest rates unchanged, the central bank basically delivered exactly what the market was anticipating with very little surprises to spice up the euro and reinvigorate risk appetite.

The Good News

The good news was that the ECB agreed to purchase bonds of weaker nations on the secondary market to bring down borrowing costs through a program called Outright Monetary Transactions (OMT). The purchases will be on the short end of the curve with maturities of 1 to 3 years, have no minimum credit threshold and are unlimited in size. The central bank will also put themselves on the equal footing with other bondholders, which means giving up their seniority. This will only be for the OMT program and not the Securities Market Programme or SMP. IMF involvement will also be sought which suggests that any nation seeking the help of bond purchases by the ECB could become subject to Troika review if the IMF wants to get involved.

The Bad News

In a nod to the Germans, the bad news is that strict conditionality will be attached to the bond purchases and if troubled countries fail to comply with fiscal and structural reforms, these purchases can be cancelled by the ECB. The SMP will also be terminated and replaced by OMT, which isn’t as stimulative as having both programs running simultaneously. The fact that bond purchases will be sterilized is also a disappointment because it waters down the ECB’s influence on the market and the region’s economy by neutralizing the impact on the money supply. The main difference between this program and other bond buying is the conditionality or the Enhanced Condition Credit Line (ECCL). According to ECB President Draghi, this conditionality is important and can mean the difference between the program’s success and failure because it give clear metrics and stakes for governments seeking support from the ECB. Aid could be yanked if nations fail to comply with reform conditions for bond purchases.

In terms of the economic outlook, the central bank grew more pessimistic and cut their 2012 growth forecasts to a range of -0.6 to -0.2% from a prior forecast of -0.5% to 0.3% and said the risks to growth is on the downside. They raised their inflation forecast to a range of 2.4% to 2.6% from 2.3% to 2.5% and said risks are broadly balanced.

In our ECB preview, we posed 6 questions for the ECB, all which were answered:

1. Will the ECB Cut Interest Rates? – No Rate Cut
2. What Maturities will the ECB buy under their New Bond Purchase Program? – 1 to 3 Year Maturities
3. Will they Target a Specific Amount for Bond Purchases? – Unlimited Bond Purchases
4. Will there be a Yield Cap? – No Yield Cap
5. Will Bond Purchases be Sterilized? – Bond Purchases Will be Sterilized
6. Will they wait for the German Court’s Ruling Before Finalizing their Plan?- Yes, Bond Purchases Depends on ECB Conditionality

The sell-off in the EUR/USD reflects the market’s disappointment with the ECB. They may not have brought their BB gun to the range today but they certainly didn’t bring their bazooka. Although Spanish bond yields have fallen since the ECB’s announcement, the central bank failed to introduce a grand sweeping plan to control bond yields and the price action in the FX market confirms that investors were not impressed.

Kathy Lien
Managing Director

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