Are Fed / ECB balance sheet shifts driving EUR / USD?

Recent US dollar weakness against the euro, like the rally earlier in 2021 and a May-December 2020 slide, may reflect differential growth in net lending to government by the Fed and ECB. Fed net lending has been rising faster recently, possibly contributing to an excess supply of dollars, but the ECB may move back into the lead in H2, suggesting support for the US currency.

Eurozone balance of payments figures, available through March, show a record net outflow of direct and portfolio capital in late 2020 / early 2021. The outflow swamped the current account surplus, resulting in a record “basic balance” deficit, which may have driven a Q1 decline in EUR / USD – see chart 1.

Basic balance positions of currency areas, according to monetary theory, are influenced by the relative pace of domestic credit expansion (DCE), defined as bank lending to government net of government deposits plus lending to the private sector. Central banks have been a key driver of DCE in recent quarters via their QE operations and changes in their government deposit liabilities.

Chart 2 shows stocks of net government lending by the Fed and ECB, together with their ratio. A rise in the ratio implies faster “liquidity creation” by the Fed than the ECB, which – other things being equal – would be expected to imply upward pressure on EUR / USD.

There have been three distinct phases since covid struck:

• The Fed launched additional QE earlier and on a much larger scale than the ECB, resulting in a surge in the ratio in spring 2020. The dollar moved into excess supply, reflected in a sharp rise in EUR / USD into August, with a further move higher into year-end.
• The Fed’s stock of net government lending went into reverse in mid-2020 as a slowdown in QE coincided with a Treasury build-up of cash in its general account at the central bank. PEPP buying, meanwhile, boosted growth of ECB net lending. The rise in relative euro supply resulted in an outflow of Eurozone capital in late 2020 / early 2021, with associated EUR / USD weakness in Q1.
• The Fed / ECB net lending ratio rose again from January as the Treasury ran down its general account balance from more than $1.6 trn to below $800 bn currently, partly to finance $380 bn of stimulus payments over March-May. This has been reflected in a Q2 rebound in EUR / USD towards a December high of 1.23.

What next?

ECB purchases of government securities are currently running at about €110 bn per month versus Fed buying of Treasuries of $80 bn. The Treasury’s latest financing estimates assume a further fall in its balance at the Fed to $450 bn by end-July but a recovery to $750 bn by end-September. The suggestion, therefore, is that the ECB’s stock of net government lending will grow faster than the Fed’s between now and end-September.

Eurozone governments, moreover, could choose, like the Treasury, to reduce their current large cash balance with the ECB, giving an additional boost to net lending and euro supply – chart 3.

The Fed / ECB net lending ratio could rise further in June / July before turning down and the last three EUR / USD moves began only after a new trend had been established. H2 is looking more promising for the dollar but confirmation of a shift in relative liquidity creation is required.