One may be tempted to think that a bailout from the European Central Bank (ECB) will send the euro higher against the U.S. dollar because it will calm Eurozone debt crisis fears.

However, the opposite may actually happen, according to a research note from Deutsche Bank (DB).

The research states that there is a “remarkably strong” relationship between EUR/USD and the size of the Eurosystem’s balance sheet. (The Eurosystem consists of the ECB and the central banks of Eurozone members).

That is, when the ECB expands its balance sheet, the euro tends to fall against the U.S. dollar.

The correlation, using a 3 months growth rate since 2010, is 84 percent, according to DB (graphs below). 

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Since 2010, a 10 percent increase in Eurosystem assets is associated with a 9 percent decline in the euro against the dollar; an expansion of 200 billion euros would be associated with EUR/USD dropping below 1.30 from currently levels.

This relationship, of course, is of key interest currently given the imminent rescue package from Eurozone leaders, which DB and others believe will quite possibly involve a direct or indirect expansion of the ECB’s balance sheet.

Even if ECB isn’t involved in the bailout, it will still likely have to “continue buying periphery debt in size,” stated DB, thereby expanding the size of its balance sheet.

Why does this relationship exist between the ECB balance sheet size and EUR/USD?

DB noted that it’s not a causal relationship of ECB liquidity causing lower EUR/USD; EUR/USD actually leads the Eurosystem balance sheet size by one week.  Instead, DB suggested that “the events surrounding balance sheet expansion…are EUR negative.”

These events are generally those associated with Eurozone financial stress.  This association may also suggest that ECB liquidity expansion may not solve financial stress, at least not immediately, because the balance sheet-EUR/USD correlation is positive.  

Moreover, the research suggests the level of EUR/USD is primarily driven by events in the Eurozone (i.e. those “surrounding [Eurosystem] balance sheet expansion”) instead of those in the U.S.

E-mail Hao Li at hao.li@ibtimes.com.

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