Euro sub 1.20 plunge could worsen as central banks dump

<p>The euro began the first full trading week of 2015 by breaking below the $1.20 level for the first time in four years to end […]</p>

The euro began the first full trading week of 2015 by breaking below the $1.20 level for the first time in four years to end up hitting a nine-year low of $1.1864. The latest reasons for the renewed slump are the rising probability that the Greek anti-bailout left alliance will win the 25th January elections, combined with apparent tolerance from German Chancellor Merkel over the possibility of a Greek exit, and emerging consensus that even if outright QE of euro sovereign bonds were agreed on by the European Central Bank, the plan would fail to rid the Eurozone of deflation.

Are central banks’ dumping euros?

Further propagating the euro’s decline was the latest data from the International Monetary Fund, showing central banks’ euro-denominated foreign exchange holdings fell to 22.6% in Q3 2014, reaching the lowest level in 12 years.

The proportion of euro holdings fell over the last three consecutive quarters on record. In contrast, the proportion of central banks’ USD-denominated currency holdings rose to 62.3% – the highest level since Q1 2011.

One potential problem with interpreting these figures is that the percentages reflect the change of value, suggesting that the change in proportion could be a result of the change in value of the currency impacting the value of holdings, rather it being a reflection of actual central bank dumping or adding currencies. This is highlighted by the positive correlation between the EUR/USD chart and the percentage of EUR holdings.

This phenomenon is further justified by the fact that central bank holdings of Japanese yen rose between Q1 2009 and Q3 2012 from 2.78% to 4.27%. Certainly the rise was a result of the yen’s 20% appreciation during the same period, rather than central banks being drawn to the yen’s non-existent yield.

Whether the depreciation of a currency feeds into actual central bank selling of the currency is a valid question. The more important dynamic is the direction of the currency, especially when moving in tandem with central bank holdings. Another factor is the reallocation into other such as the Aussie and Canadian dollar, whose share of central bank holdings increased to about 2.0% over the last two years.

Currency weakness is key priority

The resurging threat of a Greek exit, coupled with the fear that Eurozone inflation may drop and remain stuck at or near zero percent has accelerated the euro’s falling momentum after the ECB’s implementation of its fourth operation of long-term financing, while the purchase of covered bonds and asset-backed securities failed to make a difference in the data. The ECB has little choice but to begin purchasing Eurozone sovereign bonds at its 22nd January meeting.

And, in the likely event that Draghi fails to secure majority among the Governing Council in favour of QE this month, we expect a resolution to this to materialise later in Q1 or Q2 2015. But not before the deflationary situation deteriorates further.

For currency traders, the situation is becoming more straightforward.

Regardless of whether QE takes place or not, Draghi has assured the ECB’s balance sheet will return to 2012 levels, which means it will increase by at least €550bn to €750bn over the next two years. And regardless of the policy mix pursued, euro weakness will be part and parcel of it.

Having broken below its 200-month moving average for the first time in 12 years, EUR/USD will fail from staging any real recovery above 1.25 until a break of 1.16 is shown this quarter at least in one occasion.

 

Central Bank FX allocation Jan 5 2015

Join our live webinars for the latest analysis and trading ideas. Register now

GAIN Capital UK Limited (trading as “City Index”) is an execution-only service provider. This material, whether or not it states any opinions, is for general information purposes only and it does not take into account your personal circumstances or objectives. This material has been prepared using the thoughts and opinions of the author and these may change. However, City Index does not plan to provide further updates to any material once published and it is not under any obligation to keep this material up to date. This material is short term in nature and may only relate to facts and circumstances existing at a specific time or day. Nothing in this material is (or should be considered to be) financial, investment, legal, tax or other advice and no reliance should be placed on it.

No opinion given in this material constitutes a recommendation by City Index or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although City Index is not specifically prevented from dealing before providing this material, City Index does not seek to take advantage of the material prior to its dissemination. This material is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

For further details see our full non-independent research disclaimer and quarterly summary.