It May Be A Weak Dollar Story, But Europe Is Center Stage In The Week Ahead

Coins, Banknotes, Money, Currency, Finance, Cash

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Europe is center stage in the week ahead. It is not as if there are not other important events or economic data due out. After all, the US reports both the consumer and producer price indices -- as does China -- along with its reserves, trade, and lending figures. However, for investors, the events in Europe may overshadow them.

The European Central Bank meeting is the highlight of the week ahead. Traditionally, officials have been wary of pre-committing to a policy change, but this time they seem to have all but promised to move. And for a good reason. The recovery has stalled and a contraction here in Q4 is possible. The pandemic and social restrictions are hitting the economy, even if the impact is less than earlier this year.

The ECB has one mandate: price stability. The year-over-year change in the headline CPI has been stuck at minus 0.3% for three consecutive months through November. It has not been above zero since July. The core rate fares better, barely. It has been at 0.2% for the past three months and has never been lower.

The ECB has signaled that while the full range of its policy tools are available, it will focus on two of them. First, it will expand and extend the Pandemic Emergency Purchase Program. It had been topped up to 1.35 trillion euros over the summer and extended to the middle of 2021 before the recent surge in the virus. The market expects the PEPP to be increased by 400-600 billion, and for the program to be extended to the end of next year.

Some talk circulated ahead of the weekend about the possibility of a longer extension into 2022. Yet this seems to be less relevant to most market participants and may not be needed with the prospects for a vaccine. Also, the ECB is not committed to using its full PEPP program, which means extending the duration beyond the end of next year may not be a powerful signal.

Second, there is expected to be another offering of long-term loans at quite favorable rates (50 bp less than the minus 50 bp deposit rate, or three-year loans at minus 100 bp), provided that certain lending targets are achieved.

Yet, with the broad outlines largely in the market, the central bank may need to do more to spur a constructive response by investors. In comments to Reuters last week, ECB Chief Economist Lane suggested there were other dimensions of policy relating to collateral, swaps and repo operations, and the amount of deposits at the ECB that could be exempt from the negative deposit rate. While officials assure that there is scope to cut the minus 50 bp deposit rate, it seems in no hurry.

Both the loans and the bond-buying (net maturing issues and loan servicing) add to ECB's balance sheet. It has risen from nearly 4.7 trillion euros at the end of last year to roughly 6.9 trillion at the end of November. At the end of 2019, the central bank's balance sheet accounted for almost 39.5% of GDP. Now it's close to 63.5%. In comparison, the Federal Reserve's balance sheet has risen from about 19.5% of GDP to 34.5%.

While there may be benefits to the flexible bond-buying, it has limits. The link between the expansion or the size of a central bank's balance sheet, on the one hand, and inflation and exchange rates, on the other, is tenuous at best. Japan's experience is also consistent with this conclusion. And at the same time, the low core inflation reading reflects in part the response to the pandemic, such as a temporary cut in the German VAT and bringing forward seasonal sales. In Japan, the government tried to spur tourism by giving discount vouchers.

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Read more by Marc on his site Marc to Market.

Disclaimer: Opinions expressed are solely of the author’s, based on current ...

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