The relationship between the euro and the ECB’s balance sheet broke down in the middle of the year. This could be a sign of currency traders front-running the ECB. The ECB has promised a lot and traders have aggressively shorted the euro. With the TLTROs and covered bond/ABS purchases having a muted effect (the take up for the ECB’s second TLTRO auction last week was underwhelming), traders are betting on an imminent sovereign QE. If the ECB fails to meet these expectations, currency speculators could begin to take profits on their short euro positions.
The sharp drop in oil prices further increases the importance of the ECB policy for the euro. The eurozone’s current account stood in a record surplus of €250 bn in the last twelve months. This has occurred even as oil imports have been steadily increasing. The eurozone’s oil import bill totaled over €300 bn over the last year. As this declines with lower oil prices, it will push the current account surplus to new record highs and exert greater upward pressure on the euro.
The way the ECB views the drop in oil prices will be vital. With headline CPI rising just 0.3% yoy, there is a reasonable chance that inflation could turn negative. If the ECB sees this as a temporary outcome and does not react with more monetary accommodation, the euro will be pulled higher by the growing current account surplus.
Our FX strategists are long the euro against a basket of the U.S. dollar and British pound.