Reuters Report Triggers a Brief Relief Rally for the EUR

ECB plans to tighten excess liquidity capture market attention.

The major foreign exchange rates are maintaining narrow trading ranges as we approach the release of the latest policy updates from the Federal Reserve (Fed), Bank of England (BoE), and Bank of Japan (BoJ) later this week. This follows a substantial sell-off at the end of the previous week, which was triggered by the European Central Bank's (ECB) latest policy meeting. The euro, however, showed signs of a modest recovery yesterday, reaching an intraday high of 1.07199, surpassing the low it hit at the end of the previous week, which stood at 1.0632.

The primary catalyst for the euro's rebound yesterday was the release of a report from Reuters citing ECB sources. The report was titled "ECB to Address Excess Liquidity in Next Phase of Inflation Combat."

Source: Reuters (https://www.reuters.com/markets/europe/ecb-tackle-excess-liquidity-next-stage-inflation-fight-sources-2023-09-18/#:~:text=Discussions%20on%20how%20to%20reduce,steering%20short%2Dterm%20interest%20rates.)

According to this report, the ECB is likely to initiate discussions on how to address excess liquidity during its upcoming policy meeting scheduled for October 26th. The report also suggests that interest rates are expected to remain unchanged at least until December, as outlined in the report. Policymakers are now turning their attention toward reducing excess liquidity, with three key areas of focus:

Reserves Held by Banks: There is a proposal to increase the percentage of customer deposits that banks must hold at the ECB, potentially raising it from the current 1% to a figure closer to 3% or 4%. Currently, mandatory reserves amount to EUR165 billion, whereas excess liquidity stands at around EUR3.7 trillion.Unwinding Bond Purchases: Policymakers are considering the gradual phasing out of the ECB's Pandemic Emergency Purchase Programme (PEPP) by not replacing matured bond holdings. However, a decision on this matter may not materialize this year and is unlikely to take effect before early 2024 or even later in the spring.Interest Rate Framework: Some policymakers are exploring potential changes in the interest rate framework. However, it remains uncertain whether the ECB will continue with the current floor system or revert to a corridor system, given the substantial excess liquidity in the system.

EURO AREA EXCESS LIQUIDITY REMAINS WELL ABOVE PRE-COVID LEVELS

Source: Bloomberg, Macrobond & MUFG Research

The Reuters report follows a study presented at the ECB's Sintra symposium, indicating that with the diminishing need for monetary stimulus, the ECB could reduce bank liquidity to a range between EUR521 billion and EUR1.4 trillion while still meeting banks' reserve requirements. Bloomberg reports that excess liquidity in the euro area has declined to approximately EUR3.7 trillion from its peak of around EUR4.8 trillion in September of the previous year. However, this level remains significantly higher than pre-COVID shock levels observed in late 2019, which were around EUR1.7 trillion.

While the ECB's reported plans to address excess liquidity have provided some support to the euro, they are unlikely to be the sole factor reversing the current weakening trend. Any adjustments to current policy settings are not expected to occur before early next year at the earliest, thereby limiting near-term support.

This content may have been written by a third party. ACY makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied by any third-party. This content is information only, and does not constitute financial, investment or other advice on which you can rely.