Euro key part of ECB 8217 s ABS plan

It is debatable whether today’s euro rally was a result of the European Central Bank’s announcement that to begin purchasing Eurozone asset-backed securities and covered bonds as early as this month, or whether it is a result of the ECB’s reluctance to provide details on the size by which its balance sheet will increase. An increase in the ECB balance sheet tends to be a negative for the currency because it raises the supply of money into the system.

But the most important part of the announcement is that the ECB is ready to buy as much as €1 trillion in loans and mortgages over two years. WithECB president Draghi stating the purchases of ABS and covered bonds would expand the size of the balance sheet to 2012 levels, from the current €2.04 trillion, the currency impact is unlikely to be positive.

Not a bad bank

Much criticism and concern has already emerged about the ECB’s to include some junk-rated loans from Greece and Cyprus, with some dubbing the ECB as a “future bad bank”. It is worth reminding that Ireland’s National Asset Management Agency (NAMA), whose task was to buy distresses Irish debt in 2009-2010, has seen assets grow by more than 40%. The ECB’s Securities Market Program of 2010, which included distressed Greek bonds, also left the central bank with considerable profits.

The objective of the ECB is far from being a bad bank. Instead, the goal is to broaden holdings across the Eurozone in order to boost the value of periphery loans and help local banks free up valuable liquidity for future loans to households and business that need it most.

Markets expect the ECB will purchase about €200 bn in ABS and covered bonds per year. The amounts could increase once the ECB extends the list of eligible assets in terms of quality and sector.

Currency component remains crucial

Realising that the ECB priority is to lift inflation towards the 2.0% from the current 0.3%, a weak euro shall remain part and parcel of any balance sheet program it decides to pursue. The euro fell 10% from its May highs. But we must remember that when Eurozone inflation rose from -0.6% in July 2009 to 3.0% in October 2011, it was aided by 21% decline in the euro. A worrying fact is that that the euro’s 20% decline between summer 2011 and summer 2012 failed to boost any rise in inflation due to the far reaching implications of austerity policies and plummeting consumer demand. Is it fair to expect another 5-7% decline the currency? The ECB will not mind it. For the Fed, it is another story.