Overview of Liquidity Conditions in Euro Area

The euro has surpassed the 50% retracement of the slide since Oct 17 when it peaked near $1.3140.  The 61.8% retracement comes in near $1.2960 and is seen as the next immediate objective.  

The driving force is not the fundamental strength of the euro area economy.  The PMI trumps the IFO and points to a Q4 contraction, including for Germany.   Nor it is it a reflection of the successful conclusion of the recent meetings on Greek aid and the EU 7-year budget.   Of course, a deal is likely, but the rancor and mental and accounting gymnastics that are required do not speak well of the process.  

There have been a number of positive developments in terms of liquidity and financial variables within the euro zone.  We are not suggesting here these are the drivers for the  euro's recovery since mid-month, but they do suggest the temperature of the fire in which they find themselves caught is not burning quite as bright.  

Look at deposits.  The latest data is for the month of September and covers both retail and corporations.  Spanish deposits rose 4 bln euro to 897 bln euros, the highest since June.  Italian deposits rose almost 22 bln to 1.07 trillion, the highest since Jan 2003.  Deposits in Greece rose 823 mln euros to 149.4 bln, the highest since May.  

Look at Target2 imbalances.  They have been reduced on the margins.  The latest data covers the month of October.  The Bundesbank's claims stood at 719 bln euro, down from a peak of 751 bln in August.  This is down 32 bln euros in the month.  The Bank of Spain's liabilities fell to 384 bln euros from a record 420 bln euros in September.  This is the BoS smallest liability since June.  The Bank of Italy's liabilities fell 14 bln euro to 267 bln in October.  The record was set in August just below 290 bln euros.   Greece's imbalance was essentially unchanged at 108 blm euros, which is the most since Nov 2011. 

National central bank borrowing from the ECB remains elevated.  Spain borrowed a record 400 bln euros from the ECB in September, 11 bln euros more than in August.  Italy borrowed 5 bln less from the ECB in September than August or 275 bln euros in all.  Portugal borrowed 56.1 bln in September, an increase of about 500 mln euros, which is the most since July.  

To this should be added the ECB's approval of emergency lending assistance (ELA).  It rose almost 2.2 bln euros to 235 bln in the week to Nov 16, the most since the beginning of H2.  

Overall the ECB's balance sheet expanded 3 bln euros in the week to Nov 16, which is the first increase since late September.  As Europe approaches the first year anniversary of the LTRO, there is risk that some who took the 3-year funds will exercise their option to return the funds early.  The funds returned will reduce the ECB's balance sheet, just at the moment in time when the Fed's balance sheet is poised to expand. 

Most investors and observers would agree that there are numerous drivers of foreign exchange prices.  Relative monetary conditions are one set of them.  In the short run, the correlation between monetary conditions and nominal bilateral currency rates is hardly stable.