EURUSD drop may have further to go given that the relative policy outlook would push Fed/ECB balance sheet ratio lower before long. Citi's Valentin Marinov believes, relative data surprises as well as forward looking cyclical gauges like bank stocks are starting to favor USD over EUR and he points out that leveraged accounts could start adding to shorts again as real money continue to sell EUR.
The July ECB meeting underscored the prospect for larger ECB balance sheet from here. The upcoming Fed minutes and speeches as well as Yellen’s semi-annual testimony in coming weeks could highlights that the bank is firmly on course to exit QE before long. The diverging policy outlook should be reflected in falling Fed/ECB balance sheet ratio (Figure 1).
The divergence is further underscored by the growing disparity between positive economic surprises out of the US and disappointments out of the Eurozone (Figure 2).
The data seem to have fuelled concerns about renewed cyclical downturn in the Eurozone while strengthening market belief in the US recovery. Given that bank stocks are a good forward looking gauge of cyclical outlook, the latest development pushed the EZ/US bank stocks ratio lower again (Figure 3).
Last but not least, investor positioning seems to suggest that leveraged accounts cut their EUR-shorts and could add again as real money keep selling the euro (Figure 4).
We expect the ratio of ECB/Fed balance sheets to move lower before long. Given the historic correlation between EURUSD and the ratio of Fed/ECB balance sheet - this should underscore the downside risks to EURUSD (Figure 1). We simulate that ECB/Fed balance sheet ratio assuming that:
1/ The ECB's balance sheet would expand by ca 250bn as a result of the two T-LTRO tranches in September and December 2014. This follows on our assumption that about 150bn of T-LTRO would be taken up by banks in the periphery and (mostly) used to repay LTRO loans. The T-LTRO take-up is assumed to increases by 100bn in March and June 2015.
2/ The ECB balance sheet grows by additional EUR1tn of unsterilized ABS and government bond purchases in June 2015;
3/ The Fed's completes taper by October but continues to reinvest proceeds from its portfolio thus keeping the size of its balance sheet.