Conclusion: The ECB has massively increased its balance sheet over the last six months relative to the Federal Reserve. This trend is likely to continue, which is bearish for the Euro.
In the race to the bottom of the world’s currency markets, the actions of both the Federal Reserve and the ECB are central (no pun intended) to determining the relative value of currencies. In the charts below, we show the increase in the balance sheets of both central banks starting from 2003 to the most recently released data from this week.
In aggregate, both charts show the massive amount of stimulus that central banks have injected into the global economies over the past nine years with the vast majority coming in the last three years with the onset of the “Great Recession”. In aggregate, since 2008 the two central banks have added more than $4 trillion to their balance sheets.
Over recent quarters, the Federal Reserve has halted the expansion of its balance sheet. In fact, from the start of the year to the most recent data reported on June 20th, 2012, the Federal Reserve has actually seen its balance sheet decline marginally by about $43 billion, or just under 2%.
In the same period, the balance sheet of the ECB has expanded by an estimated $410 billion. This is an increase of just under 12% for the ECB’s own balance sheet, a dramatic relative increase versus the Federal Reserve’s decline of 2%.
The primary driver of this relative acceleration in the size of the ECB balance sheet has been the ECB’s LTRO 1 and LTRO 2. In aggregate, these two programs have handed out more than $1.3 trillion to more than 1,000 European banks. Collectively, this is larger than the Federal Reserve’s much ballyhooed TARP program and quantified easing (albeit QE is a different policy tool, as well).
As the ECB has taken a much more aggressive stance with its balance sheet, it should be no surprise then that the Euro has had a serious correction versus the U.S. dollar in the year-to-date. This decline has been accelerated over the past three months as the FXE, the CurrencyShares Euro Trust etf, is down 6.3%. (Incidentally, we’ve had some solid success trading the FXE, being correct 13 of 16 times in the Virtual Portfolio with the aggregate gains substantially larger than the aggregate losses.)
Since 2010 the relative size and relative growth of the Federal Reserve’s balance sheet versus the ECB’s has had a direct correlation with the value of the Euro versus the U.S. dollar. Even as the Euro has weakened versus the U.S. dollar in 2012, it does seem as if some of this lock step relationship has alleviated, which may imply further downside in the Euro versus the U.S. dollar.
If we accept that the future direction of the size of the central bank’s balance sheet is a decent proxy for either more hawkish or more dovish monetary policy, then there are a couple of scenarios:
- QE3 is imminent – In effect, the currency market is pricing in incremental quantitative easing from the Federal Reserve. Based on the most recent commentary from the Federal Reserve, this seems to be an unlikely scenario in the intermediate term as they did nothing last week but extend Operation Twist. In effect, this action is merely equivalent to not tightening.
- QE3 is not imminent and intervention in Europe continues – If the monetization of debt / lender of last resort continues to be an ECB led activity, the balance sheet of the ECB should continue to expand. Given the situation in the European banking system, this seems a very likely scenario. In fact, as we’ve highlighted, Italy and Italian banks are the next potential shoes to fall in Europe with massive pending maturities and accelerating credit default swaps. It is highly likely that the ECB will continue to have to step up and support its banking system.
The growth in size of the respective balance sheets of the ECB versus the Federal Reserve is a key factor in determining the direction of the currencies. The recent expansion of the ECB balance sheet and likely continued expansion portend negatively for the Euro versus the USD.
Daryl G. Jones
Director of Research
