Impact of ECB's March QT

The ECB gave a far in advance notice that it would start shrinking its balance sheet, but will conditions be different by the time it happens?

The short-term improvement

Before the ECB meeting, it was reported that EuroZone CPI retreated for the first time in 18 months, though it stayed in double digits. The German-Italian yield spread (seen as a gauge of financial risk in the sharing economy) continued to move lower. Both could be seen as signs that the economic situation in Europe is improving.

But Europe is facing seasonal risks from the effect of winter. So far, the energy situation has remained stable. The regulator reduced the threat level, despite some unseasonably cold weather bouts. However, the real impact will be known in March, including the effect on inflation and the economy.

It's a short period

Lagarde announced that the ECB would run off an average of €15B a month, which is about half of the debt that matures each month. This is a small fraction of the €5T held by the bank and minor compared to the Fed's $95B a month program. Even so, there is concern about the potential impact on the markets. The ECB pre-announced a program lasting only three months for just €45B. Lagarde also promised that the bank would provide additional details in February and revise the plan based on the evolution of the data.

The ECB has a generally optimistic outlook for the start of next year based on the assumption of no significant energy-related issues. By March, the weather is improving, and the potentialimpact of energy prices on inflation might be significantly muted. Also, the ECB is expected to raise rates further by that time. According to the shared central bank's projections, inflation is expected to be significantly lower by then. All of that adds to a picture suggesting a relatively minor impact from QT - assuming there are no surprises through the winter.

EUR/USD restricted by structural deficiencies

EURUSD started to consolidate its upward spiral after putting in a high at $1.0736. Although another bullish leg is probable, it is unlikely to surpass $1.08 (R1) quickly. If momentum increases, $1.0936 (R2) and $1.1185 (R3) are higher above. Due to its structural weakness, the pair might be exposed to a pullback, if not a full-blown reversal. Losing the floor at $1.0481 (S1) will open the door to $1.0350 (S2), where a right shoulder of a potential H&S pattern could print. Otherwise, the slide might continue towards $1.0222 (S3) - a major support bulls defend.

Key takeaways

The ECB is set to begin reducing its balance sheet in March 2023, potentially impacting markets. The bank has an optimistic outlook for the short term and expects inflation to be lower, with the potential for further rate hikes. The impact of the balance sheet reduction, known as quantitative tightening (QT), is expected to be relatively minor, assuming there are no surprises related to energy-related issues.