Euro strength. Should we worry?
September 7, 2020
The Financial Times appears to have caught investors’ attention quite a bit over the past few days. Although most questions were on the role of options and other derivatives in the sharp gyrations of tech stocks, one or two did spot that some European central bankers intervened in the currency market – verbally. By saying that the euro/dollar exchange rate does feed into their macro forecast and, therefore, into their monetary policy considerations, they were likely trying to mitigate the recent euro strength. But is a strong currency always a bad thing? Within reasonable levels, we don’t think so. It all comes down to what’s driving the foreign exchange markets. Let’s see why.
Euro strength... Should we worry? Whether an appreciating currency is good or bad for economic growth, inflation and corporate earnings depends on why this is happening. If the cause of euro strength is an economy that’s growing faster than elsewhere, then currency appreciation is a consequence of economic outperformance and that’s a good thing. If it’s just because a foreign central bank is easing monetary policy faster than the European Central Bank while the euro area is weak, then it’s a bad thing. Consider these two scenarios:
- Strong euro when the euro area is growing: Imagine a world where the euro area continues along its process of integration, perhaps by completing banking union and building on the EU recovery fund to start some sort of fiscal union. In this scenario, the fall in risk premia is likely to boost economic and earnings growth. So foreign capital may flow in, thus supporting European risk assets and strengthening the euro.
- Strong euro when the Fed is easing: Now imagine a world where the global economy is in recession, hit by yet another financial crisis or a new virus outbreak. In this scenario, if the Fed eases policy more aggressively than elsewhere, the US dollar is likely to weaken versus other major currencies. Euro appreciation would then tighten financial conditions for the euro area just because real rates are falling faster in the US.
Here’s why this matters:
The euro side of the story: In part, euro strength is a good thing because it has to do with the euro area making progress towards fiscal integration. We believe that the EU recovery fund will likely secure parliamentary approval over the next few months and start disbursing funds backed by joint debt issuance next year. Over time, this could possibly provide the European Union with a single, safe and liquid debt instrument. This process should increase confidence in the long-term prospects of Europe, thus attracting financial flows from abroad and strengthening the currency. We believe that all this isn’t fully priced in just yet. The more it does, the more the euro should get stronger.
The dollar side of the story: In part, euro strength is a bad thing because it has to do with the Fed lowering real rates faster than the ECB. This is because nominal yields have more room to fall in the US, while they’re already negative almost across the whole curve in core European countries. And it’s also because inflation expectations appear to have risen more in the US, where markets seem less sceptical about a possible rise in inflation relative to the euro area. The resulting drop in US real rates is putting downward pressure on the dollar and weakening it especially versus the euro.
Meanwhile, all eyes on the ECB this week.
Speaking up: We expect the ECB to continue to intervene verbally and, if needed, announce extra monetary easing over the next several months. While the upcoming policy meeting this Thursday is probably too soon for significant action, at the very least we’d expect a downgrade of the growth and inflation projections, thus paving the way for additional stimulus when the time comes.
FX musing: We don’t think it’s going to be a straight line for the euro/dollar exchange rate. Possible ECB intervention suggests more like a range-bound trend around current levels until year-end. But we expect the euro to strengthen further over the next 12 months. We see the euro/dollar exchange rate to get to 1.25 at end-2021 – within the range of fair-value estimates.
Chief Economist & Macro Strategist
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