EURUSD has tracked the divergence between the relative balance sheets of the Fed and the ECB quite tightly since the financial crisis, but now, with the ECBs balance sheet shrinking and the Fed continuing with its asset purchases, that link with EURUSD is being undermined.
The reason appears to be the potential for the ECB to impose negative deposit rates.
Of course, the euro is likely to come under pressure ahead of next weeks ECB meeting, with investors mindful that Mario Draghi, the central banks president, said he was open to the idea of negative deposit rates at the last get-together.
Since then, some ECB council members have backtracked on the idea, notably Frances Christian Noyer, who said this week he was unconvinced about the merits of negative rates.
Still, investors will be wary of the potential impact of negative deposit rates on the euro, especially in light of a sell-off in the Danish krone after the Danish central bank cut rates in July 2012 in a bid to stem haven flows into Denmark.
Danish krone slides after cut in deposit rate
Certainly, negatives rates appear to be one of the few remaining tools capable of boosting activity in the eurozone.
That is because, with the political consensus ensuring fiscal policy cannot be loosened in the region, the burden falls on the ECB and monetary policy.
However, the central bank cannot conduct large-scale asset purchases like the Fed, the Bank of Japan or the Bank of England because Draghi has argued the Treaty on the Functioning of the European Union forbids it.
Neither can the ECB loosen policy by large purchases of ABSs backed by loans to small and medium-sized companies, even if it wanted to, because such securities do not exist in sufficiently large scale.
That leaves cutting deposit rates into negative territory as the main weapon in the ECBs arsenal. Although most believe the central bank will shy away from using that tool at next weeks meeting, any sign it is considering it later in the year will create headwinds for the euro.
However, Valentin Marinov, strategist at Citi, says it will not just be investors who are long of the euro who will be concerned about the prospect of negative deposit rates.
He points out that the Danish experience demonstrated that penalty deposit rates led to large losses for banks holding excess cash with the central bank.
We suspect that the eurozone banks may speed up the repayment of their LTRO loans if talk about negative deposit rates were to intensify, says Marinov.
This in turn could accelerate the contraction of the ECBs balance sheet relative to the Fed.
EURUSD and the ratio of ECB vs. Fed balance sheet
However, rather than supporting EURUSD, as has previously been the case, Marinov believes the single currency could suffer even as the ECBs balance sheet falls relative to the Feds.
Sharper contraction of the ECB balance sheet could go hand in hand with a weaker euro as it would signal growing concerns about bank losses related to penalty rates on excess reserves in coming months, he says.
Interestingly, Citi also believes that further drops in banks excess reserves could also make it easier for the ECB to penalize eurozone banks for holding excess cash with the central bank.
In theory, negative rates should encourage banks to lend. However, if negative deposit rates result in bank losses, such as in Denmark, it could hamper lending rather than encourage it.
Indeed, in Denmark, the losses taken on their excess reserves undermined banks overall financial position, resulting in the lending rates on some bank loans increasing in the month after the introduction of negative rates.
Taking that into account, Citi believes investors could start focusing on the evolution of bank excess reserves in the eurozone, especially those held by banks in the core of the region, as an important driver of the likelihood of negative deposit rates.
Ironically, the steeper the drop in the ECB balance sheet from here, the likelier the implementation of penalty rates, says Marinov.
With that in mind, one could argue that the correlation between the relative size of the ECB and Fed balance sheet and EURUSD could even become negative in coming months.
It would seem the euro is in the process of losing a long-term pillar of support.