ECB & EUR: Pouring oil into the fire

As we wrote earlier, the European central bank announced a series of measures, hoping the several, targeted but smaller measures can make a difference.

On first glance, it's nothing overwhelming and underscoring the view that the ECB's usual unconditional toolkit (for cutting rates further into the negative territory and increasing QE meaningfully) is largely exhausted and government actions on the fiscal side must be taken to make a difference to the economy.

Under normal circumstances, the apparent lack of dovishness from the ECB would lead to a stronger EUR and higher EUR/USD, particularly if the Federal Reserve is likely to cut interest rates aggressively and speculation about the Fed's QE plans continue to rise. Yet, two factors lead to the weakening, rather than strengthening of the cross:

1. The clear break down in markets, where funding issues in the cross-currency basis swaps market and the sharp decline in equity markets pushed USD higher across the board (even against the safe-haven yen). See USD: The wrong kind of rally for more
2. The lack of perceived conviction from ECB President Christine Lagarde that the central bank is willing to do whatever it takes to help euro asset markets.
   The remarks “we are not here to close spreads” do risk re-introducing a risk/credit premium into EUR assets and are reminiscent of pouring oil into the fire. The widening of the BTP-bund spread, as shown below in the figure provides the case in point.