This month, one of the interviewees for our Strategy Review advises us to “look at the strength of the euro”.

Since July 2013, the single currency has risen from about $1.28 to $1.33. Over the same period, a similar trend was in place against sterling – until August saw a string of healthy macro numbers out of the UK, boosting the pound. GBP/USD has gone from $1.49 to $1.58. If this reflects expectations for monetary policy, it’s clear that the UK is perceived to be tightening fastest, with the ECB next and the US bringing up the rear – even after all the talk about the ‘tapering’ of the Fed’s QE programme.

It’s easy to forget that the Fed hasn’t started mopping up all of its excess liquidity, and won’t do so for some time yet. In fact, its balance sheet has grown by 25% this year, to $3.7trn. By contrast the ECB’s balance sheet has shrunk by more than 20%, and now stands at €2.36trn. Moreover, 58% of that shrinkage is accounted for by repayments of longer-term refinancing operations (LTRO), the ECB’s equivalent to QE.

In other words, forget the Fed’s ‘tapering’ – the ECB is already sucking excess liquidity from the eurosystem. This was what our interviewee wanted to open our eyes to.  

“The market regards the ECB as overly tight,” he said. “The same kind of thing happened in 2011, when the euro was strong for all the wrong reasons – banks withdrawing capital from emerging markets to plug their own liquidity gaps. 

A shrinking ECB balance sheet combined with Fed ‘tapering’ would be “a liquidity squeeze” that “could be quite dangerous for the periphery and for France”, he warned.

Of course, the most optimistic interpretation would be that the euro-zone crisis has passed and healthy banks are handing back cash they don’t need. That’s probably true, but in doing so they may persuade the central bank to leave sickly institutions dry. An upward drift in EONIA over the summer, with some nasty spikes, certainly raised questions. The optimists also have to explain why M3 growth remains so weak, and especially why loans to the non-financial corporate sector have been shrinking.

Our interviewee’s evocation of 2011 will cause readers to remember Jean-Claude Trichet’s disastrously premature rate hike that year. Is the ECB making the same mistake again?

Mario Draghi seems alive to the risks.

“Weak loan dynamics continue to reflect primarily the current stage of the business cycle, heightened credit risk and the ongoing adjustment of balance sheets,” he said at his 5 September press conference. “We view the current excess liquidity as adequate, but we stand ready to act.”  

The correct level of excess liquidity is “context-dependent”, he added. Specifically, it depends on the extent of fragmentation in the eurosystem. That surely makes the bank stress tests due in Q2 2014 vital for ECB monetary policy: between now and then, second guessing by the market as liquidity tightens further will probably lead to a pick-up in euro-zone bond volatility