© European Central Bank

- Euro strengthens after ECB eases monetary policy.

- Analysts seek to explain rise, offer multiple reasons.

- Two main camps argue over future trajectory of EUR.

The Euro has been on a roller coaster ride in the wake of the European Central Bank (ECB) interest rate decision Thursday and now analysts are offering their views on which aspect of the announcement caused such volatility.

The Euro dropped to within a hair’s breadth of its 2019 lows against the Dollar Thursday and then recovered just as rapidly, before ending the day on a high. Gains came despite the ECB easing policy in a manner that normally results in a weaker currency by increasing the supply of Euros, or ‘liquidity’, on the market.

Some say the wild swings were partly due to the market expecting the ECB to be even more aggressive than it was, although two other reasons have also been given for why the Euro rose following the decision.

Above: Euro-to-Dollar rate shown at hourly intervals after ECB decision Thursday.

The first reason is that although the ECB cut the deposit rate for commercial banks from -0.4% down to -0.5% (in order to stimulate lending), it also introduced a tiering system whereby the negative rates wouldn’t apply to a significant proportion of the deposits held by those banks at the ECB.

Negative rates are effectively a charge on deposits but the tiering clause means not all banks will have to pay the higher rates on all their funds. The -0.5% rate will only apply to funds in excess of 6 times a given bank’s minimum reserve requirement, meaning a large amount of deposits will be exempt.

“This multiplier has initially been set at six, which means that just under €800B worth of reserves can now “potentially” be stashed at the ECB at zero rates,” says Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics.

The end result is that liquidity may actually be drained as banks opt to park money at the ECB for 0.0% rather than invest it in sovereign bonds which offer no more than a negative yield, meaning investors stand to lose money if they hold them to maturity.

“Tiering absorbs EUR liquidity from the interbank market by increasing the relative ECB deposit return,” says David Adams, a strategist at Morgan Stanley. "A tiered deposit rate suggests that policy rates have approached the effective lower bound. President Draghi urged fiscal expansion, an indirect recognition of the monetary policy toolbox's shortcomings."

Above: Euro-to-Dollar rate shown at daily intervals on Friday.

The ECB introduced tiering to shield the vulnerable Eurozone banking system from the negative side-effects of negative interest rates, one of which is lower profitability. The other main reason why the Euro strengthened after the meeting is to do with the other policy initiative the ECB launched, namely a fresh round of quantitative easing (QE) in which it buys bonds from commercial banks in order to help speed up the passthrough of lower interest rates into the real economy.

The ECB did not state an end date for QE - a move seen as ushering in potentially unlimited QE - something which should be expected to weaken the Euro. But the ECB is facing a diminishing supply of bonds that it can buy, especially sovereign bonds, which could impose a natural limit on the new asset purchase program. The ECB set itself some rules in 2015 that mean there are limits to the proportion of a country's government bond supply that it can own, although it could always change those rules.

“It as if we have all been drinking what the Hitchhikers’ Guide to the Galaxy calls “the best drink in existence”--Pan-Galactic Gargle Blasters--the effects of which are similar “to having your brains smashed out by a slice of lemon wrapped around a large gold brick.” Except in this case it was Pan-Galossian Gargle Blasters we were drinking,” says Michael Every, a strategist at Rabobank. "We got our brain smashed out by a slice of lemon wrapped around a large gold brick as the market started to realise that QE can only run for around 12 months before there is nothing sovereign left to buy. Furthermore, it was revealed that rather than being unanimous, this policy decision was rejected by Germany, France, the Netherlands, Austria, and Estonia."

The Euro may have risen in the aftermath of the meeting but where is it expected to go longer-term? There are two main camps in this regard. The first expects EUR/USD to rise as the ECB finds it has no more room to ease policy whilst the U.S. Federal Reserve, conversely has a substantial amount of space to cut interest rates and ease. The second is that the pair will fall because the Dollar remains much more attractive from a yield and safe-haven perspective than any other G10 currency.

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