The European Central Bank (ECB) may have to take over the Federal Reserve’s role in providing liquidity if it is going to protect the Eurozone’s budding recovery, say Societe Generale analysts Patrick Legland and Daniel Fermon. The introduction of forward guidance may be just the first step necessary to keep bond rates low, maintain liquidity, and prevent the euro from appreciating too quickly.

ECB

ECB pushing interest rates down

“Financial conditions have tightened in the eurozone since Mr Bernanke first commented, on 22 May, on the possibility of tapering the Fed’s asset purchases,” they write. And even though the tapering delay has helped somewhat, “our strategists still have a 3.25% forecast for 10-year UST for year-end, which means rate volatility is here to stay.” Since the ECB can’t lower rates any further, forward guidance is meant to push long-term rates down by assuring banks that short-term rates aren’t going up any time soon.

long term bond trends

Banks repaying LTRO funds

Liquidity has been falling as a result of banks repaying LTRO funds (longer-term refinancing operations), which could drive up the Eonia (Euro Overnight Index Average) just as international rates are being driven higher by tapering. ECB President Mario Draghi has said that another round of LTRO is being considered, and “the ECB may also consider introducing a fixed or capped rate on the new LTRO to anchor medium-term expectations,” Legland and Fermon write.

In addition to fighting instability caused by the Federal Reserve’s decision, these funds would help bolster the Eurozone if the credit landscape continues to get worse, and would help banks get through the upcoming Asset Quality Review.

eu excess liquidity 0913

Euro slowing global growth

“A strong euro is a major hurdle particularly in the context of slowing global growth, competitive devaluations from Japan, and downtrending EM FX,” write Legland and Fermon, and the Euro has been appreciating since the Fed announced it wasn’t ready to begin tapering. If this continues unchecked, European exports will suffer, threatening the EU recovery.

eurozone exports nad euro 0913

“Fed-induced instability, evaporating liquidity and a resilient euro could all convince the ECB to act in the coming months,” the analysts write, giving investors a chance to get some additional value by investing in European equities, particularly in peripheral EU countries.