FX Briefing : ECB Embarks on Exit from Unconventional Measures

Highlights

• Uncertainty on Dubai debts abates
• Japanese government opposed to yen appreciation
• ECB Council planning to move out of crisis mode
• Euro firm against the dollar, but no major breakout so far

The dollar, which had firmed last week after the news of Dubai World's debt problems, lost ground again during the course of the week. Most market participants regard Dubai World's request to restructure its debts as a serious matter, but with only a limited impact; there are latent fears, however, that further "debt problem cases" could come to light eventually. On the whole, uncertainty has abated.

The ECB governing council meeting was the second, and perhaps more important, reason why the dollar was weaker. Comments made by ECB president Jean-Claude Trichet and other council members in the run-up to the meeting had signalled clearly that the ECB would embark on its exit from unconventional measures – contrary to the Fed, which is emphasizing credit supply problems as well as under-utilisation of production capacity, and has so far shown little inclination to reduce quantitative easing.

Correspondingly, in the run-up to the meeting, EUR-USD gradually edged up to last week's levels again. On Thursday morning, the European single currency rose over 1.51. However, even though the ECB has announced a relatively ambitious plan to unwind emergency measures, the euro has been unable to breach 1.5145. Given the unexpectedly good labour market figures, markets are more likely to speculate on the Fed starting to tighten monetary policy.

USD-JPY is moving in its own stratosphere. Last week, after some contradictory comments on currency intervention from the Ministry of Finance, the dollar had dropped below 85 against the yen, a 14-year low. This week, the government seem to be unanimous about not wanting to risk any further appreciation of the yen. Prime Minister Yukio Hatoyama himself commented that the current strength of the yen was not acceptable. Furthermore, the Bank of Japan decided at an extraordinary meeting to extend its quantitative easing measures: it is launching an additional 10 trillion yen facility to offer banks loans against a wide range of collateral. Subsequently, USD-JPY recovered to over 88.

ECB embarks on "quantitative tightening"

The market had been expecting the ECB to discontinue its 12-month tender next year, and had also considered it possible that the rate for the December 12-month tender could be calculated on average refinancing costs during the maturity period. But the ECB has gone even further: it has decided that the last 6-month tender will be carried out in March; furthermore, after the third maintenance period ends in April, only weekly and monthly tenders, if any, are likely to be offered using a full allotment fixed rate tender procedure. This suggests that, as from Q2, the 3- month tender could be offered at a variable rate again.

The measures the ECB is embarking on are likely to ensure that liquidity, which at the moment is mostly provided on a long-term basis, will be available on a short-term basis instead. At latest, this will be the case at the beginning of July 2010, when the €442bn one-year tender matures. However, the ECB could tighten monetary policy again in the second quarter, if it so wished, as excess liquidity has already been reduced significantly, and now "only" about €60bn are being placed in the deposit facility on average.

The ECB has asserted that the latest measures are not linked to any interest rate policy intentions. This is likely to be the case for the time being. However, it is also clear that very short-dated money market rates will rise towards the refinancing rate again when money market management is no longer in crisis mode and excess liquidity is drained from the market. Moreover, it only makes sense to offer the forthcoming oneyear tender at a fixed rate if one is at least toying with the idea of raising the refi rate within the relevant time-frame.

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