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An interpretation of the euro’s reaction euro may be that, in addition to the uncertainty weighing on the euro area growth and inflation scenario, the market may have perceived a split within the ECB on the timing and operational details of QE. And the fact that the euro lost ground when Draghi said that a tapering of purchases wasn’t discussed, either, could be viewed as an implicit indication that the option of extending QE has not been ruled, at least in theory. However, there is a long way to go between “not ruling out” and “implementing”, and ultimately this is what will make the difference in terms of the exchange rate. Which leads us to the next point. 

2. What will the ECB do in December

Excluding the option of a tapering, paradoxically, for the very fact that the ECB did not even discuss this option at its latest meeting, in December the central bank could essentially do two things: announce that QE will not be extended, or announce that it will be extended.

Non-extension of QE

In case of a “non-extension” of QE, the euro would strengthen, both in function of a possible upside effect on yields at the end of the purchase programme, and because a non-extension would presumably reflect an improvement (possibly even modest, but perceived as stable) of the growth and euro area inflation picture. Initially, the impact reaction could be a rather evident rebound of the exchange rate, as to date the market seems to be attaching a low probability to the programme not being extended.

However, the upside effect should wane subsequently, and margin should be limited, as the exchange rate will continue to respond also to the behaviour of the Fed, which next year will in any case hike rates, albeit gradually, whereas the ECB will keep them at zero. The baseline scenario would therefore continue to point to a prevalently lateral movement, mostly within the EUR/USD 1.10-1.15 range.

Extension of QE

In case of an “extension” of QE, presumably by a further six months, until September 2017, the euro may weaken; however, if the extension is read as the last act of the ECB’s long expansive cycle, the weakening could be contained, both in terms of size and duration.

The QE programme could be extended in two ways: (i) extension of purchases at the same pace as at present, or (ii) extension at a slower pace (smaller purchases than at present).

(i) In the first case, which implies technical implementation problems, the decline of the euro could be stronger due to a slightly broader depressive effect on yields, although downside should in any case remain limited to within the 2015 lows of EUR/USD 1.05-1.04.

(ii) In the second case, which to date seems to be the likeliest outcome (for technical reasons as well), the weakening of the euro should be more modest (within 1.07-1.06, with robust supports already in the EUR/USD 1.07 area).

Beyond the near term, however, as also if QE is not extended, lateral dynamics should resume, in function of a policy combination by which the Fed will hike rates next year and the ECB will keep them at zero, despite being in the final phase of its expansive cycle.

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