by Vicki Schmelzer

NEW YORK, Nov 29 (MNI) – European Central Bank’s failure Tuesday,
to sterilize its weekly bond purchases, has been red-flagged as a
potential precursor to full fledged quantitative easing.

If indeed, as some suspect, the ECB is about to embark on a larger
scale QE plan, like other central banks before it, the euro will likely
suffer, analysts said.

However, if ECB actions serve to allay risk aversion and peripheral
spreads narrow, new risk positioning could act to underpin the euro,
they said.

Earlier, the ECB drained E194.1986 billion from the banking system
in a seven-day liquidity-absorbing operation intended to sterilize the
ECB’s purchases of Eurozone government bonds.

The amount fell short of the E203.5 billion targeted, which is the
cumulative total spent by the ECB in bond buys since the start of the
program in May last year minus any bonds that have matured in the
meantime.

One likely reason explaining the shortfall — the first since May
— is that banks prefer to remain very liquid and park funds using the
central bank’s overnight deposit facilities. This highlights the
fragility of confidence and concerns that a step-up in the crisis might
require the precautionary funds parked at the ECB to be utilized.

Richard Franulovich, Westpac’s New York based currency strategist,
preferred to wait to see what the ECB does going forward before assuming
the central bank is poised for more aggressive action.

“This is not the first time this has occurred — it also happened
for a couple weeks back in April,” he said.

“It is noteworthy however, that this is the first time since
purchases were expanded to include Italy and Spain,” Franulovich said.

How the ECB handles the situation in coming weeks will be telling.

“If it’s one week, ‘I am curious’, if it’s two weeks, ‘it’s
interesting,’ if it’s three weeks, ‘I’m interested, if it’s four weeks,
‘it’s a pattern,’ but if it’s five weeks — it’s QE,” Franulovich said.

This week’s ECB short-fall was under E10 billion, certainly “not on
a par with the Fed’s program,” but “a decent program,” nevertheless.

If coming weeks see a similar sized mismatch, the amounts will
begin to “add up,” he said.

As for the impact of ECB QE on the euro, “we could get both
outcomes,” he said.

Lower Eurozone yields would act to weigh on the euro but this could
be offset by the prospect of the ECB taking more aggressive action,
which could improve risk sentiment, Franulovich said.

Ultimately however, fundamentals probably will hold sway.

The dollar and sterling both moved lower in response to initial QE
action by the Fed and BOE and the euro is likely move lower on ECB QE
also.

“There is a strong history to suggest that QE will weaken the
euro,” Franulovich said.

Nick Bennenbroek, senior currency strategist at Wells Fargo, also
maintained that ECB quantitative easing would act as a headwind for the
euro.

“If the market thinks that the ECB actions will more closely
resemble QE by the Fed and BOE, then I believe the euro would be weaker,
and perhaps substantially weaker,” he said.

Much depends however on the market’s response to QE and whether or
not old “risk-on/risk-off” correlations hold.

“The euro may not benefit as much from stabilized market conditions
as previously,” he said.

If low Eurozone rates make the euro a funding currencies. “I don’t
necessarily think it (improved risk sentiment) is going to help the euro
this time,” Bennenbroek said.

Nevertheless, with market positions extended (CFTC positions show
speculative positions holding a euro short of -85,068 as per Nov. 22,
the largest net short since June 8, 2010), there is scope for a knee
jerk rally higher in response to a credible Eurozone crisis resolution.

“Credible” is the operative word, in that the only way for the euro
to gain a toehold back over $1.4000 would be for the market to believe
that the ECB or whatever entity (International Monetary Fund) has enough
firepower to keep the market liquid and narrow peripheral spreads, he
said.

Otherwise, the prospects of lower Eurozone interest rates, for a
longer period than previously expected, will likely weigh on the euro.

“You could see a move from $1.35 to $1.40, but I still think we
will be $1.20 or $1.25 in 12-months time,” Bennenbroek said.

The euro was trading at $1.3325 Tuesday, in the middle of a $1.3284
to $1.3442 range.

Traders have been surprised that the euro has not taken out the
$1.3145 low seen October 4 so far this month. This was expected in light
of recent peripheral spread widening and now the prospects of ECB QE.

Earlier, the pair broke above $1.3404, the downtrendline from the
Oct.27 peak at $1.4245-50, another promising sign, they said.

Nevertheless, a clear-cut close above the trendline would be needed
to suggest that a larger move back above $1.3500 was in the works.

For now, the focus remains on a retest of the October lows, the
psychological $1.3000 level, and then the 2011 lows near $1.2870.

All eyes are on the EU heads of State summit, taking place in
Brussels December 9, with soundbites leading up to the event expected to
drive the euro in the near-term.

** Market News International New York Newsroom: 212-669-6430 **

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