Impact of ECB exit on the euro: It's all about sequencing – Deutsche Bank

The research team at Deutsche Bank, investigates how an exit from unconventional ECB policy would impact the euro and finds that “not all tightenings are created equal” and argue that it is the sequencing of the exit, rather than the overall monetary policy stance, that will determine whether the euro appreciates. 

Key Quotes

“A policy focused on an early exit from negative rates would be very bullish for the euro. We show that FX is far more sensitive to front-end rather than back-end yields and that this sensitivity has dramatically increased after the 2008 financial crisis. We also show that the effects of negative rates are highly non-linear, so that an early ECB hiking cycle will have a disproportionately positive impact on FX.”

“In contrast, a policy focused on a tapering of the ECB’s PSPP program would not be bullish for the euro. QE operates via signaling effects on the short-term rate path as well as by depressing term premia. If the ECB is able to keep the front-end anchored, a rise in term premia alone could have bearish implications for the EUR via reduced demand for European fixed income. Similar effects were observed around the Fed taper tantrum.”

“Taking it all together, we re-iterate our bearish EUR/USD outlook. We expect EUR/USD to reach and break parity by next year. Our expectations are conditional on the ECB first winding down QE rather than initiating an interest rate hiking cycle. Our forecasts would survive a “one off” rise to the deposit rate, provided it stays negative. If the ECB was to signal an exit different from the above, our EUR/USD view would change.” 

“Specifically, in the case of rate hikes, the EUR would likely strengthen more against G3 and GBP than against the continental periphery. FX-rate betas are generally higher in G4, and unlike Fed QE, ECB QE primarily resulted in portfolio outflows to the other G4 economies. The UK looks particularly vulnerable to a reversal of “Euroglut” flows. In the continental periphery, EUR/SEK has become most sensitive to ECB sequencing.”