European Policy Could Hurt Euro

The European Central Bank is expected to implement some form of monetary easing at its June policy meeting this week, having potentially adverse affects on the euro.

Jun 2, 2014 at 3:57PM

The European Central Bank is expected to implement some form of monetary easing at its June policy meeting to combat weak economic and loan growth. The ECB has so far cut interest rates close to zero and pumped extra liquidity into the banking system, but loans to the private sector continue to fall. Loan data released Wednesday showed that loans to the private sector in the European Union fell by 1.8% in April from the same month a year earlier.

Howard Archer, economist at IHS Global Insight, told Reuters that the drop in lending and money supply growth "keeps up the pressure on the ECB to deliver a package of stimulative measures at its 5 June policy meeting." Archer's comments come on the heels of ECB chief Mario Draghi's statement on Monday that the central bank must be "particularly watchful" for any negative price spiral in the eurozone.

Draghi's fear of deflation
The ECB has been on guard against deflation since late last year, when the annual inflation measure dipped below 1%. To guard against a drop in price expectations, "more pre-emptive action may be warranted," Draghi said in a speech entitled "Monetary policy in a prolonged period of low inflation." Draghi mentioned after the ECB's May meeting that the Governing Council was "comfortable with acting next time," referring to its June policy meeting, but wanted to see updated economic projections from the bank's staff first.

The most recent inflation forecast is 0.7%, significantly below the ECB's target of around 2%. The ECB may choose to cut its deposit rate, already at zero, at next week's meeting, effectively charging banks for holding their cash overnight. Draghi has also indicated that full-blown, U.S.-style quantitative easing -- i.e., printing money to buy assets -- remained an option for the ECB. He justified his statement by saying that destabilizing inflation expectations "would be the context for a broad-based asset-purchase program."

While Europe may in theory like to fire a monetary "bazooka" to reignite inflation growth, getting all of the region's members to agree on such drastic policy may be difficult. Unlike the U.S. and Japan, the eurozone cannot simply open up the monetary coffers and expect unemployment rates to fall across the board. Different structural issues remain among the various European countries, but continued low interest rates and some form of monetary stimulus should help offset the fiscal problems.

Easing measures spark falling interest rates
With all the hype surrounding monetary easing in the eurozone, global interest rates have had trouble moving higher in 2014. The German 10-year Bund yield fell to a low of 1.34% on Wednesday, and the U.S. 10-year Treasury moved in lockstep toward a new 2014 low of 2.44%. Falling interest rates have for the most part been a function of the loosening of monetary policy across the globe. At this point, however, some countries, such as the U.K. and the U.S., are taking their feet off of the monetary gas pedal, while countries in Europe and Japan remain committed to increasing price pressures. 

Similarly, in 2014 as the U.S. dollar has fallen, even in the face of tighter monetary policy, global investors have chosen to buy the euro during times of global anxiety. This has led to a negative correlation between the euro and iShares MSCI Germany Index Fund (NYSEMKT:EWG). German equities are a good indicator of equity market strength in the eurozone, considering Germany has the region's strongest and most stable economy. If the euro does continue to fall in the coming weeks due to monetary injections from the ECB, expect German equities not only to move higher, but also to lead other equity indexes across the globe.

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